The two formulas
CAPM prices equity from risk the stock cannot diversify away. Beta measures how strongly the stock moves with the market, and the market risk premium is the extra return investors expect from the market over a risk-free asset. WACC then averages the cost of each source of funding by its share of total capital.
Re = Rf + beta x (Rm - Rf). WACC = (E/V) x Re + (D/V) x Rd x (1 - Tc). E and D are the market values of equity and debt, V = E + D, Rd is the pre-tax cost of debt and Tc is the tax rate. CAPM comes from Sharpe's 1964 work, and both formulas are standard in corporate finance textbooks such as Berk and DeMarzo.
A worked example
A company has $600,000 of equity and $400,000 of debt at market value. The risk-free rate is 4%, beta is 1.2 and the market risk premium is 5.5%. Its debt yields 6% and the tax rate is 25%. These are teaching numbers, not current market data.
| Piece | Weight | Rate | Contribution |
|---|---|---|---|
| Equity (CAPM: 4% + 1.2 x 5.5% = 10.60%) | 60.00% | 10.60% | 6.36% |
| Debt after tax (6% x (1 - 0.25) = 4.50%) | 40.00% | 4.50% | 1.80% |
| WACC | 100.00% | 8.16% |
A project with the same risk as the company should be discounted at 8.16%. If the same company moved to half debt and half equity, the weights would shift toward the cheaper source, but the cost of equity would also rise because the shareholders carry more risk. This simple calculator holds the rates fixed, so use it for the capital structure you have entered.
Choosing the inputs
Take the weights from market values: share price times shares outstanding for equity, and the market value of debt, or book value as a rough stand-in when the debt is not traded. For the cost of debt use the yield the company would pay today to borrow, not the coupon printed on old bonds.
The risk-free rate is usually a government bond yield with a maturity close to the project's life. Betas come from data providers or a regression of the stock's returns against the market. For the market risk premium, use a current, dated estimate from a source you can name; Aswath Damodaran at NYU Stern publishes one regularly. If a problem gives you the expected market return instead of the premium, switch the calculator's selector and it subtracts the risk-free rate for you.
Mistakes that cost points
- Weighting by book values. The weights should reflect what investors would pay today.
- Using the pre-tax cost of debt. Interest is deductible, and that tax saving is why debt looks cheaper inside WACC.
- Plugging the market return into the premium slot of CAPM. The premium equals the market return minus the risk-free rate, so subtract first.
- Typing 6 in one box and 0.06 in another. This calculator takes percents everywhere.
- Using the coupon rate from an old bond as the cost of debt when the yield has moved.
Estimate for learning, not financial advice. Inputs stay in your browser and are not sent or stored.