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Explain why beta may increase WACC in a recession?

Explain why beta may increase WACC in a recession?

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Answer #1

Cost of capital or WACC is the required return on an investment project. It includes debt and equity funding. The cost of equity is generally found using the Capital asset pricing model. The equations for wacc and cost of equity are as follows:

Wacc - Cost of equity * weight of equity + Cost of debt * weight of debt

Cost of equity as per CAPM = Risk free rate + Beta * Market risk premium.

Beta reflects the stock's volatility visa vis the market. So a higher variability in the beta affects the variability of the cost of capital. Beta is the most volatile factor in the components of wacc. During a recession there is added volatility in the beta of a stock due to conditions in the market. So during a recession a higher beta may lead to higher wacc.

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