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for the entire market of stocks since Boeing has a beta coefficient of 1.00; and for JPMorgan Chase,
this expected return is 12.0%.
The last point to understand is that the CAPM expected return is also the required return for any
common stock. Given the risk of the stock as reflected in its beta coefficient, the current risk-free rate
of return, and the proxy market risk premium, investors must expect to earn the CAPM return;
otherwise they will not invest in that stock. The capital asset pricing model, therefore, is widely used
to determine the cost of equity capital for a company. The CAPM equation produces the return that
investors must expect to earn if they are to hold the common stock of a company, which is the cost of
equity capital for the company.
Cost of Capital
All companies calculate their cost of capital as a part of the investment analysis process. Capital is
required to fund internal investment projects, and this capital has a cost. Once a company‟s cost of
capital is known, this cost is used as the hurdle rate when evaluating investment projects. If a project
earns a rate of return in excess of the cost of capital, it should be accepted. If a project earns a rate of
return below the cost of capital, it should be rejected.
One more important point must be made here: We calculate the cost of capital provided to the firm
by external investors, that is, long-term lenders and stockholders. These investors provide long-term
capital to the firm, which is invested in long-lived projects, and they expect to earn an appropriate
risk-adjusted return from their investment. This is why it is called the cost of capital. We omit sources
of funds like accounts payable, wages payable, and taxes payable, for example, because they do not
come from long-term lenders and stockholders. These are short-term sources of funds that do not carry
an explicit cost and are typically created by the day-to-day operations of the firm. So remember to
focus on the firm‟s long-term capital sources and the cost of these sources.
The cost of capital for a firm is the cost of its debt capital, plus the cost of its common and preferred
equity capital, weighted by the relative amount of debt and common and preferred equity in the firm‟s
capital structure. This is called the weighted average cost of capital (WACC) and is calculated with
the following formula:
This formula tells us the weighted average cost of capital for a firm is its current cost of debt capital
(K debt ), times the relative weight of debt in the capital structure (W debt ), times 1 minus the corporate tax
rate (1 - t), plus its current cost of common equity capital (K common equity ), times the relative weight of
common equity in the capital structure (W common equity ), plus its current cost of preferred equity capital
(K prefequity ), times the relative weight of preferred equity in the capital structure (W prefequity ). Calculating a
company‟s WACC is a mechanical process that requires determining the value of all the input
variables in the formula and combining them into the WACC. We examine each input to the formula
and the end result in the next section.