2014•Unpublished venueRequires access

Iterative Process Using CAPM to Calculate the Cost of Equity Component of the Weighted Average Cost of Capital

James R. Morris

Abstract

This chapter expands on an iterative process to consider the additional complexities when the capital asset pricing model (CAPM) is used to calculate the cost of equity that is used as a component in weighted average cost of capital (WACC), and also when it is used directly in calculating the value of equity. The issue that is addressed is that the valuation problem is circular, or simultaneous, in that we need to know the cost of capital to calculate the values of invested capital and equity, but we need to know the values in order to calculate the cost of capital. The chapter shows two examples to demonstrate how to handle this problem with an iterative process: (i) the percentage of debt to equity in the capital structure is assumed to remain constant; and (ii) the capital structure is assumed to be changing over time.

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Key concepts: Weighted average cost of capital, Cost of capital, Cost of equity, Capital asset pricing model, Economics, Residual income valuation, Return on capital, Valuation (finance)