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The weighted average cost of capital (WACC)
The CAPM formula and the beta factor
Required return (k e) = R f + β [E(R m) – R f ]
Where β = the ‘beta factor’ – a measure of systematic risk
Rf = risk-free rate of interest
Rm = return on market portfolio
Rm – Rf = market premium
β = 1 is the average for the market
NB: It is assumed that investors are well diversified
Theory: The CAPM gives a required return for a given level of
systematic risk.
Therefore, if we can estimate the level of risk associated with an
entity (the beta of the entity), we can use CAPM to give a required
return to shareholders.
This required return to shareholders is essentially the cost of equity
which can then be used to derive an appropriate WACC for the entity.
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