Cost of capital: CAPM and WACC

Unlevered free cash flow belongs to both lenders and shareholders, so we discount it at the weighted average cost of capital (WACC): the blend of the returns each group requires, weighted by its share of the company's capital at market values.

Shareholders bear more risk than lenders, so equity is the more expensive source. Its cost is not observable and is usually estimated with the capital asset pricing model (CAPM).

The intuition: WACC is an opportunity cost. Investors who fund the company could put the same money into other investments of similar risk. The WACC is the return they give up, so it is the minimum return the business must earn on its capital to create value. Discounting at it asks: what would I pay today for these future cash flows, given what I could earn elsewhere at the same risk?

CAPM explains why equity holders demand more than lenders. Investors can diversify away risks specific to one company, so the market only rewards systematic risk — exposure to the economy as a whole. Beta measures that exposure: a beta of 1 means the stock tends to move with the market, above 1 more than the market, below 1 less. A utility with stable demand usually has a low beta; a cyclical manufacturer a high one.