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Example derivation of weighted average cost of capital using capital asset pricing model (CAPM)

Target 1 ÷ Target
proportion of proportion of
equity capital equity capital

Industry Company
unlevered beta levered beta (ß)
(ß)

Expected
inflation rate

Expected Nominal Weighted
nominal return Real return on Real market risk Nominal market company risk Cost of company average cost of
stock market
risk premium
equity capital
on market premium premium equity capital
Expected real Weighted
return on average cost of
long-term debt capital
Expected Pre-tax cost of After-tax cost of Weighted
company risk company debt company debt average cost of
margin capital capital debt capital

Marginal
company tax
rate

Target
proportion of
debt capital

Figure 4: Example derivation of weighted average cost of capital using capital asset pricing model (CAPM)
relatively easily from the actual interest play and influence the valuation given to intellectual capital and its impact
rate paid or that would be paid on any the business. on financial performance.
borrowings. However, the cost of equity In the next article we will look at the y Identify your industry growth rates.
is far more complex to determine, as, second critical success factor — the y Establish an agreed view of the
effectively, it is the return a company creation of robust forecasts, which can business’s WACC.
must provide shareholders to maintain a then be discounted to provide a y Start reviewing investments in
steady stock price. Technical guidance is discounted-cash-flow valuation. intellectual capital alongside other
to use a method like the capital asset investments.
pricing model (CAPM) to risk-adjust the Time for action The sooner the process is started, the
expected market return, but the reality Business valuation is a complex area, greater the value opportunity or loss
of actually doing this can be difficult but a “do nothing” option is not avoidance. ■
(see the chart “Example Derivation of sustainable. Realistically, it is not
Weighted Average Cost of Capital Using possible to create a definitive business
Capital Asset Pricing Model (CAPM)”). valuation because so many factors are Paul Ashworth, FCMA, CGMA, is a
Difficult as it may be, it is essential to subjective and people will assign value Jersey, British Isles-based practising
have a view on your company’s WACC. differently. However, incremental management accountant providing
So long as this is in the right ballpark, improvements in this area can deliver strategic insight and enabling business
then it can be used as a benchmark for significant benefits even whilst the intelligence systems in financial and
comparison of returns from potential capability is still being developed. business services, and public-sector
investments. In the event of a merger or Some initial actions to take are: organisations. To comment on this
acquisition, the precise WACC employed y Design an in-house centre of article or to suggest an idea for
is more critical, but at that time there expertise in value measurement another article, contact Oliver Rowe at
will also be various other factors, such as and management. Oliver.Rowe@aicpa-cima.com.
a takeover premium, which come into y Improve understanding of
FM-MAGAZINE.COM February 2022 I FM MAGAZINE I 31