What is the Difference Between CAPM and WACC?
🆚 Go to Comparative Table 🆚The difference between the Capital Asset Pricing Model (CAPM) and the Weighted Average Cost of Capital (WACC) lies in their definitions and purposes. Here are the key differences:
- Definition: CAPM is a risk/reward model that quantifies the relationship between systematic risk and expected return for assets, particularly stocks. On the other hand, WACC is the average after-tax cost of a company's various capital sources, including common stock, preferred stock, bonds, and any other long-term debt.
- Purpose: CAPM is used to estimate the cost of equity and helps investors determine the expected return on an investment. WACC, however, focuses on a company's cost of capital and is used to calculate the blended average cost of all capital sources.
- Calculation: The cost of equity calculated from the CAPM can be added to the cost of debt to calculate the WACC. CAPM formula: Cost of Equity = Risk-free rate + (beta * (market rate - risk-free rate)). WACC formula: WACC = (Cost of Equity * Percent of Firm's Capital in Equity) + (Cost of Debt * Percent of Firm's Capital in Debt).
In summary, CAPM and WACC are related but serve different purposes in finance. CAPM is used to estimate the cost of equity, while WACC represents the average cost of all capital sources, including equity and debt. CAPM can be used within the WACC calculation to approximate the cost of equity, but they are not the same thing.
Comparative Table: CAPM vs WACC
The main difference between the Capital Asset Pricing Model (CAPM) and the Weighted Average Cost of Capital (WACC) lies in their purpose and application. Here is a summary of their differences:
| CAPM | WACC |
|---|---|
| Used to estimate the cost of equity | Represents the average cost of a company's various capital sources, including common stock, preferred stock, bonds, and other long-term debt |
| Based on the risk-free rate of return, beta value of the stock, and risk premium | Calculated with the firm's cost of debt and cost of equity |
| Helps investors determine the expected return on an investment | Helps companies calculate their minimum required return for a project or the hurdle rate |
| Does not provide WACC; instead, it is used within the WACC calculation to approximate the cost of equity | Provides the average rate a company expects to pay to finance its assets |
CAPM is a model that helps investors determine the expected return on an investment by estimating the cost of equity, while WACC is a measure of a company's cost of capital, which includes both debt and equity financing. CAPM can be used in conjunction with other financial analysis techniques, such as discounted cash flow analysis, or with WACC as the cost of equity.
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