The One-Line Answer
CAPM calculates the cost of equity. WACC uses that cost of equity as one of its inputs. CAPM comes first — it gives you the return shareholders require. WACC then combines that equity return with the cost of debt to give you the blended cost of all capital. They are sequential steps in the same process, not alternatives to each other.
What CAPM Does
The Capital Asset Pricing Model (CAPM) answers one specific question: what annual return must an investor expect to be compensated for taking on the risk of owning this company's shares?
The CAPM formula is:
Where:
- Re = Cost of Equity — the required return on equity
- Rf = Risk-Free Rate — typically the 10-year US Treasury yield
- β (Beta) = the stock's sensitivity to market movements
- (Rm − Rf) = Equity Risk Premium — the extra return equity investors demand above the risk-free rate
CAPM is entirely about equity. It does not consider debt, interest rates, tax, or the company's capital structure in any way. Its output is a single number — the cost of equity — that tells you what equity investors require.
What WACC Does
WACC (Weighted Average Cost of Capital) answers a different, broader question: what is the blended annual return required by all capital providers — both equity holders and debt holders — weighted by how much each has invested?
Where:
- Re = Cost of Equity — this is exactly what CAPM calculated
- Rd = Cost of Debt — the interest rate on borrowings
- E/V = Equity weight — share of total capital funded by equity
- D/V = Debt weight — share of total capital funded by debt
- (1 − Tc) = Tax shield — makes debt cheaper after tax deduction
WACC considers the entire capital structure. It blends equity cost and debt cost using their proportional weights to produce the overall cost of capital for the firm.
How They Connect — The Exact Relationship
CAPM feeds directly into WACC. Here is the step-by-step flow most finance professionals follow:
Run CAPM — Find Cost of Equity (Re)
Gather: Risk-Free Rate (current 10-yr Treasury), Beta (from Yahoo Finance or Damodaran), Equity Risk Premium (~5%). Apply: Re = Rf + β × ERP. Output: a percentage — e.g. 11.5%
Plug Re into WACC Formula
Take the Re from Step 1. Add Cost of Debt (from annual report), capital structure weights (from market values), and Tax Rate. The Re from CAPM becomes the first term in WACC.
Calculate WACC — The Blended Rate
WACC = (E/V × Re) + (D/V × Rd × (1−Tc)). This final number is used as the discount rate in a DCF valuation to find enterprise value.
Without CAPM (or an alternative method to find Re), you cannot complete the WACC calculation. And without WACC, CAPM alone cannot give you a company valuation because it only tells you about equity, not the whole firm.
Side-by-Side Comparison
📐 CAPM
- Calculates cost of equity only
- Inputs: Rf, Beta, ERP
- Ignores debt completely
- Ignores capital structure
- No tax adjustment
- Output: Re (e.g. 11.5%)
- Used to find shareholder return
- Input into WACC formula
📊 WACC
- Calculates blended cost of all capital
- Inputs: Re (from CAPM), Rd, weights, Tc
- Includes both equity and debt
- Explicitly uses capital structure
- Applies tax shield on debt
- Output: WACC (e.g. 9.2%)
- Used as DCF discount rate
- The output used in valuation
A Worked Example — CAPM then WACC
Let us calculate both in sequence for the same company, so you can see exactly how CAPM feeds into WACC.
Company data: Risk-Free Rate = 4.5%, Beta = 1.2, ERP = 5.0%, Cost of Debt = 6.5%, Equity = $6M, Debt = $4M, Tax Rate = 21%.
Step 1 — CAPM:
Re = 4.5% + 1.2 × 5.0%
Re = 4.5% + 6.0%
Re = 10.5%
Step 2 — WACC using Re from CAPM:
After-Tax Rd = 6.5% × (1 − 0.21) = 5.135%
WACC = (60% × 10.5%) + (40% × 5.135%)
WACC = 6.30% + 2.05%
WACC = 8.35%
Notice: the CAPM output of 10.5% is the cost of equity that shareholders require. But the company's actual blended cost of capital is only 8.35% — because it also uses cheaper after-tax debt. This 8.35% WACC is the rate used to discount future free cash flows in a DCF model.
Why Do People Confuse WACC and CAPM?
The confusion is understandable for three reasons:
1. Both produce a percentage. CAPM gives you 10.5%, WACC gives you 8.35%. Both look like discount rates. But they answer different questions and should never be swapped.
2. For all-equity companies, WACC equals CAPM output. If a company has zero debt, there is no debt component in WACC. The formula simplifies to: WACC = E/V × Re = 1 × Re = Re. In this special case only, WACC equals the CAPM-derived cost of equity. For any company with debt, they will always differ.
3. Both involve risk and required return. Both models deal with the idea that riskier assets require higher returns. This conceptual similarity makes them seem interchangeable, even though they operate at different levels — CAPM at the equity component level, WACC at the whole-firm level.
Common Mistakes When Mixing WACC and CAPM
| Mistake | What Went Wrong | Correct Approach |
|---|---|---|
| Using CAPM output directly as the DCF discount rate | CAPM gives cost of equity only — ignores the cheaper debt component | Use CAPM to find Re, then calculate full WACC and use that as discount rate |
| Calculating WACC without CAPM — guessing Re | Cost of equity is not observable, must be estimated methodically | Always use CAPM (or Build-Up Method for private companies) to derive Re |
| Using the same rate for equity-only and firm-level valuations | FCFE needs cost of equity; FCFF needs WACC — they are different cash flows | Match the discount rate to the cash flow type being valued |
| Applying CAPM beta directly to WACC without converting to Re first | Beta is not a cost — it is a risk measure used to calculate a cost | Beta → CAPM → Re → WACC. Never skip the CAPM step |
When Do You Use CAPM Alone vs WACC?
Use CAPM alone when you are valuing equity directly — for example, in a Dividend Discount Model or a Free Cash Flow to Equity (FCFE) model. In these cases, cash flows already belong only to shareholders, so you discount at the equity rate (Re from CAPM), not at the blended WACC.
Use WACC when you are doing a standard enterprise value DCF — discounting Free Cash Flow to the Firm (FCFF). These cash flows belong to all capital providers (both equity and debt), so you need the blended rate that represents all of their costs.
In practice, the standard DCF used in investment banking, private equity, and equity research almost always uses WACC as the discount rate. CAPM is the tool that feeds into it.
Calculate Both — CAPM then WACC — Right Now
Our WACC with Beta calculator runs CAPM automatically and feeds the result directly into the WACC formula — so you can see both calculations in one place: