More About CAPM and WACC

BY MARK O. DIETRICH

I am responding to the letter, “Direct or Indirect—CAPM or WACC?” (JofA, Feb.02, page 13) on “Taking the Temperature of Health Care Valuations” (JofA, Oct.01, page 79).

I agree with the letter writer’s analysis as to the method by which a discounted cash flow (DCF) model is used to arrive at the value of equity and that the discount rate must match with cash flow to equity or invested capital. However, I believe the article overall was correct— perhaps just a little loose with the terminology.

A discount rate can be applied for equity, for debt or the weighted average of both, otherwise known as the weighted average cost of capital (WACC). The article used “discount rate” generically, which apparently caused the letter writer’s concern.

If the equity discount rate component of the WACC is determined from the capital asset pricing model (CAPM), it is fair to say the entire discount rate (WACC) is determined from a “variation” of the CAPM. The article did, in fact, speak of exhibit 1 as illustrating the “final steps” of the DCF method, “subsequent to forecast development, calculation of free cash flows and discount rate determination.” Thus, the example did not purport to show the entire calculation of the discount rate used.

The article also spoke of a valuator’s obtaining a “discount rate” by “using a variation of” CAPM. It seems fair to read that to mean that the equity component of the discount rate was determined from the CAPM while the debt component was not specifically addressed. I think the crux of the issue is that the term discount rate was used rather than “WACC derived in part from CAPM.”

Although unlikely to be apparent to a JofA reader not involved in health care valuation, 16% is a generic WACC for health care transactions. With that in mind, I did not find the article misleading, but it does indicate a need for specificity when the authors use terms with more than one meaning.

Mark O. Dietrich, CPA/ABV
Framingham, Massachusetts

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