How to Evaluate a Company's Cost of Capital Using the Capital Asset Pricing Model (CAPM)

Evaluating a company's cost of capital is a fundamental aspect of financial management. By understanding the weighted average cost of capital (WACC), one can make informed decisions about investment, financing, and financial strategies. This article will walk you through the process using the Capital Asset Pricing Model (CAPM), illustrated through a practical example with a fictional company, XYZ Inc., which builds snarfblatts.

Understanding the Steps in Evaluating a Company's Cost of Capital

There are several key steps to follow when evaluating a company's cost of capital:

Determine the types and weights of each capital source. Determine the after-tax cost of each capital source. Add together the weighted costs to find the WACC.

Practical Example: Evaluating XYZ Inc.

XYZ Inc. is a fictional company that builds snarfblatts. They wish to expand their snarfblatt factories by issuing public stock bonds, preferred shares, and common stock. Here’s a summary of the amounts issued:

Bonds: 100,000,000 at 7% interest Preferred Shares: 25,000,000 at 9% interest Common Stock: 250,000,000

The company pays effectively 35% tax and has a stock beta of 1.5. The market premium is assumed to be 10%. Let's go through the steps to find the WACC.

Step 1: Determine the Weight of Each Capital Source

To calculate the weights, we first add up the total capital:

Total capital 100,000,000 (bonds) 25,000,000 (preferred shares) 250,000,000 (common stock) 375,000,000.

The weight of each capital source is calculated as:

Bonds: 100,000,000 / 375,000,000 0.2667 or 26.67% Preferred Shares: 25,000,000 / 375,000,000 0.0667 or 6.67% Common Stock: 250,000,000 / 375,000,000 0.6667 or 66.67%

For simplicity, let’s round the percentages to the nearest integer:

Bonds: 26% Preferred Shares: 7% Common Stock: 67%

Step 2: Determine the After-Tax Cost of Each Capital Source

The after-tax cost of capital is adjusted for taxes, which favor debt financing. Here’s the calculation for each type of capital:

Bonds: The after-tax cost of bonds is the interest rate minus the tax rate, which is 7% - 35% 4.55%. Preferred Shares: The cost of preferred shares is the same as the interest rate, which is 9%. Common Stock: The cost of common stock is calculated using the Capital Asset Pricing Model (CAPM).

Step 3: Calculate the Cost of Common Stock Using the CAPM

The CAPM is given by the formula:

Ri β * (Rm - Rrf) Rrf

Where:

Ri is the expected return on the stock (cost of equity), β is the stock’s beta coefficient, Rm is the expected return on the market, Rrf is the risk-free rate.

In our scenario, the stock beta (β) is 1.5, the market premium (Rm - Rrf) is 10%, and the risk-free rate (Rrf) is assumed to be 0% for simplicity. Now, let’s calculate the cost of common equity:

Ri 1.5 * 10% 0% 15%.

Step 4: Calculate the Total WACC

Finally, we add the weighted costs together to find the WACC:

Bonds: 26% * 4.55% 1.183%; rounding to two decimal places, this becomes 1.18% Preferred Shares: 7% * 9% 0.630%; again, rounding to two decimal places, this becomes 0.63% Common Stock: 67% * 15% 10.050%; rounding to two decimal places, this becomes 10.05%

Therefore, the WACC 1.18% 0.63% 10.05% 11.86%.

Conclusion

Through this example, we have demonstrated the process of evaluating a company's cost of capital using the CAPM. By understanding the components and calculations involved, you can make informed financial decisions that align with your company's growth strategy.

Related Keywords

Cost of Capital, Weighted Average Cost of Capital (WACC), Capital Asset Pricing Model (CAPM)