Cost of Capital: Applications and Examples, + Website, 5th Edition

APPENDIX 21A

Iterative Process Using CAPM to Calculate the Cost of Equity Component of the Weighted Average Cost of Capital¹

James R. Morris

Introduction

Capital Asset Pricing Model and Beta

Solution: The Iterative Process

Part 1: Value the Firm with Constant Capital Structure

Value of Firm Using Invested Capital Approach

Value with Changing Size Premium

Value of Firm Using Equity Approach

Iterative Process Using Spreadsheet Model

Assumptions Inherent in Weighted Average Cost of Capital

Solution: Iterative Process with Changing Capital Structure

Part 2: Value the Firm with Changing Capital Structure

Value of Firm Using Invested Capital Approach

Value of Firm Using Equity Approach

Summary

Additional Reading

INTRODUCTION

In determining the weighted average cost of capital (WACC), the market values of the capital structure components—debt and equity—are required to determine the relative weights of each component. However, this sets up a circularity issue for a closely held entity:

• Our objective is to determine the market value of the firm or the equity for the closely held business based on the WACC or cost of equity.
• However, the WACC and the cost of equity, in turn, depend on the estimated market values of the firm and the equity, the very items we are trying to determine.

Chapter 21 presents an estimation technique, an iterative process, which provides a method for handling this circularity problem. This appendix expands on the technique and considers the additional complexities ...