APPENDIX 21A

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

James R. Morris

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 ...

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