Page 111 - AFM Integrated Workbook STUDENT S18-J19
P. 111

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

                                        R f = risk-free rate of interest

                                        E(R m) = return on market portfolio

                                        E(R m) – R f = 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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