CHAPTER 12

Estimating the Cost of Capital

Chapter Outline
12.1 The Equity Cost of Capital
12.2 The Market Portfolio
12.3 Beta Estimation
12.4 The Debt Cost of Capital
12.5 A Projects Cost of Capital
12.6 Project Risk Characteristics and Financing
12.7 Final Thoughts on the CAPM

Learning Objectives
1.
2.
3.
4.
5.

Estimate a companys cost of capital using the CAPM

equation for the Security Market Line.
Describe the market portfolio and how it is constructed
in practice.
Discuss the attributes of a value-weighted portfolio.
Describe common proxies for the market return and the
risk-free rate.
Define alpha and beta and explain how they are
generally estimated.

Learning Objectives
Compare the use of average return versus beta and the
SML to estimate cost of equity capital.
7. Estimate the cost of debt, given a companys yield to
maturity, probability of default, and expected loss rate.
8. Discuss the difference between the yield to maturity
and the cost of debt when there is low versus high
default risk.
9. Calculate the cost of debt given a companys debt beta,
the risk free rate, and the market risk premium.
6.

Learning Objectives
10. Illustrate the use of comparable companies unlevered

11.
12.
13.
14.

betas or unlevered cost of capital to estimate project

cost of capital.
Discuss the advantages of using several companies
betas to estimate a project beta.
Define operating leverage and discuss its influence on
project risk.
Calculate the weighted average cost of capital.
Discuss strengths and weaknesses of the CAPM.

Financial structure (all the S-T and L-T items in liability and
equity sections of firms balance sheet.)

Current
assets

Fixed
assets

Financial structure

Balance sheet
Current
liabilities
Debt and
preference
shares
Shareholders
equity

Capital structure (the mix of L-T sources of funds used by

firms.)

Balance sheet
Current
liabilities

Fixed
assets

Capital
structure

Current
assets

Debt and
preference
shares
Shareholders
equity

Why is capital structure important?

Leverage
Higher financial leverage means potentially higher
returns to shareholders, but higher risk
(financial distress) due to higher interest payments
Cost of capital
Each source of finance has a _______ cost. Capital
structure affects the cost of capital
Optimal capital structure
The structure that _________ the firms cost of capital and
__________ firm value (shareholders wealth)

Why is capital structure important?

Capital structure theory:

Apply the cost of capital concept, and examines the

effects of financial leverage on the overall cost of capital
to firms.

10

What is the cost of capital?

______ holders and ______ holders
Often calculated and used to determine the discount rate

(with cushion); subject to risk appetite

Example

11

Cost of Capital
To understand:

1) Firms need to ensure that it has sufficient cash flows to

pay ______ of (debt/equity) capital provided by investors.
2) Investors require to earn a _____ ( debt/equity finance)
from their capital once contributed into the firm.

The cost of capital

For investors: the rate of return on a security is a

benefit of investing
For financial managers that same rate of return is
a cost of raising funds
The cost of raising ______ is the firms cost of
capital

13

Cost of capital
to evaluate individual investments;

to assess the risk of a companys

equity.

14

Cost of capital
Cost of capital is also referred to as

weighted cost of capital

weighted average cost of capital
cost of finance/funds
required rate of return of finance
hurdle rate for new investments
discount rate for evaluating a new investment

The cost of capital contd

The _______ rate that a company must earn on

investment projects in order to satisfy the required rates of

return of its investors
The rate of return on investments that leaves the price of

the firms ordinary shares unchanged

The cost of capital contd

Financing decisions

Cost of capital

Investment decisions

The choice of rate

has a significant
effect on
estimates of a
projects or a
companys _____

17

The effect of cost of capital

Too high?
________ valuable opportunities
Competitors
Too low?
Will almost commit resources to projects that will erode

profitability
________ shareholder value.

How can a firm raise capital?

By selling
Bonds
Preference shares
Ordinary shares
Each offers a rate of _____ to investors
These returns are _____ to the firm
Cost of capital actually refers to the ______ cost of

capital

19

Cost of Capital
It serves as the linkage between its ________ and

investment decisions;
It is the hurdle rate (minimum required return on an

investment necessary to cover all costs associated with a

project) that must be achieved to ________ shareholder
wealth;
Also known as firms required rate of return, the hurdle

(discount) rate for new investments, the discount rate for

evaluating a new investment, and the firms opportunity
cost of funds.

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12.1 The Equity Cost of Capital

The Capital Asset Pricing Model (CAPM) is a practical way to

estimate.
The cost of capital of any investment opportunity equals the
expected return of available investments with the same beta.
The estimate is provided by the Security Market Line equation:

ri =rf + i (E[RMkt ]-rf )

Risk Premium for Security i

Investors will require a risk premium comparable to what they

would earn taking the same market risk.

21

Textbook Example 12.1

22

Textbook Example 12.1 (cont'd)

23

12.2 The Market Portfolio

Constructing the market portfolio
Market Capitalization
The total market value of a firms outstanding shares

MVi (Number of Shares of i Outstanding) (Price of i per Share) N i Pi

24

12.2 The Market Portfolio (contd)

Value-Weighted Portfolio
A portfolio in which each security is held in proportion to its market

capitalization

Market Value of i
xi

Total Market Value of All Securities

MVi
j MV j

25

Value-Weighted Portfolios
A value-weighted portfolio is an equal-ownership portfolio;

it contains an equal fraction of the total number of shares

outstanding of each security in the portfolio.
Passive Portfolio
A portfolio that is not rebalanced in response to price changes

26

Market Indexes
Report the value of a particular portfolio of securities.
Examples:
S&P 500
A value-weighted portfolio of the 500 largest U.S. stocks

Wilshire 5000
A value-weighted index of all U.S. stocks listed on the major stock

exchanges
Dow Jones Industrial Average (DJIA)
A price weighted portfolio of 30 large industrial stocks

27

12.2 The Market Portfolio

Most practitioners use the S&P 500 (includes 500 out of

more than 7,000 companies, but it includes the largest

stocks (70%) of US market capitalization. Hence, used
as the market proxy, even though it is not actually the
market portfolio.

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The Market Risk Premium

Determining the Risk-Free Rate
The yield on U.S. Treasury securities
Surveys suggest most practitioners use 10 to 30 year treasuries
The Historical Risk Premium
Estimate the risk premium (E[RMkt]-rf) using the historical average
________ return of the market over the risk-free interest rate

29

12.3 Beta Estimation

Estimating Beta from Historical Returns
Recall, beta is the expected ________ change in the excess

return of the security for a 1% change in the excess return of

the market portfolio.
Beta reflects the _________ of each stocks to the general

performance of the economy (market).

The appropriate measure of risk for well-diversified investor.
Consider Cisco Systems stock and how it changes with the market

portfolio.

30

Figure 12.1 Monthly Returns for Cisco Stock and for

the S&P 500, 19962009

31

Figure 12.2 Scatterplot of Monthly Excess Returns for

Cisco Versus the S&P 500, 19962009

32

12.3 Beta Estimation (cont'd)

Estimating Beta from Historical Returns
As the scatterplot on the previous slide shows, Cisco tends to be

up when the market is up, and vice versa.

We can see that a 10% change in the markets return corresponds

to about a 20% change in Ciscos return.

Thus, Ciscos return moves about two for one with the overall market, so

Ciscos beta is about ___.

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12.3 Beta Estimation (cont'd)

Estimating Beta from Historical Returns
Beta corresponds to the ______ of the best-fitting line in the plot of

the securitys excess returns versus the market excess return.

34

12.4 The Debt Cost of Capital

Refers to the cost of capital that a firm must pay on its

debt.
Debt Yields
Yield to maturity (YTM) is the IRR an investor will earn from holding
the bond to maturity and receiving its promised payments.
If there is little risk the firm will default, yield to maturity is a
reasonable estimate of investors expected rate of return.
If there is significant risk of default, yield to maturity will overstate
investors expected return.

35

Table 12.2 Annual Default Rates by Debt

Rating (19832008)

12.4 The Debt Cost of Capital

(contd)

36

The average loss rate for unsecured debt is 60%.

According to Table 12.2, during average times the annual

default rate for B-rated bonds is 5.2%.

So the expected return to B-rated bondholders during

average times is 0.052X0.60=3.1% below the bonds

quoted yield.
Prob(default) x Exp. Loss Rate

37

12.5 A Projects Cost of Capital

A projects cost of capital cannot be determined by cost of

capital (since a new project is not publicly traded security)

All-equity comparables
Find an all-equity financed firm in a single line of business that is

comparable to the project.

Use the comparable firms equity beta and cost of capital as
estimates

Levered firms as comparables

38

Figure 12.3 Using a Levered Firm as a Comparable

for a Projects Risk

39

12.5 A Projects Cost of Capital (contd)

Asset (unlevered) cost of capital
Expected return required by investors to hold the firms underlying
assets.
Weighted average of the firms _____ and ______ costs of capital
Evaluating the potential cost of a capital project, by measuring the
cost of the project in a debt-free scenario.

E
D
rU =
rE +
rD
E+D
E+D

40

12.5 A Projects Cost of Capital (contd)

Asset (unlevered) beta

E
D
U =
E +
D
E+D
E+D

41

Textbook Example 12.5

42

Textbook Example 12.5 (contd)

43

Textbook Example 12.5 (contd)

44

Cash and Net Debt

Some firms maintain high cash balances
Cash is a risk-free asset that reduces the average risk of

the firms assets

Since the risk of the firms enterprise value is what were
concerned with, leverage should be measured in terms of
net debt.
Net Debt = Debt Excess Cash and short-term investments

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The Weighted Average Cost of Capital

Weighted Average Cost of Capital (WACC)

E
E
rwacc =
rE +
rD ( 1-C )
E+D
E+D
Given a target leverage ratio:

D
rwacc =rU - r
E+D

C D

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How does rwacc compare with rU?

The unlevered cost of capital (pretax WACC):
It is the exp. Return investors will earn holding the firms
assets;
Used to evaluate an all-equity financed project (same
risk);
WACC:
The eff. A-T cost of capital to the firm.
Int. expenses is tax deductible, hence WACC < exp.
Return of the firms assets.
Used to evaluate a project with the same risk and same
financing as the firm.

47

Textbook Example 12.9

48

Textbook Example 12.9 (contd)

49

12.7 Final Thoughts on the CAPM

There are a large number of assumptions made in the

estimation of cost of capital using the CAPM.

How reliable are the results?

50

12.7 Final Thoughts on the CAPM (contd)

The types of approximation are no different from those made

throughout the capital budgeting process. Errors in cost of

capital estimation are not likely to make a large difference in
NPV estimates.
CAPM is practical, easy to implement, and robust.
CAPM imposes a disciplined approach to cost of capital
estimation that is difficult to manipulate.
CAPM requires managers to think about risk in the correct way.