Topic 10 (Ch12)

Estimating the Cost of Capital

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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

Copyright 2011 Pearson Prentice Hall. All rights reserved.

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12.1 The Equity Cost of Capital

The Capital Asset Pricing Model (CAPM) is a practical way to estimate. Example 12.1 Suppose you estimate that Wal-Marts stock has a volatility of 16.1% and a beta of 0.20. A similar process for Johnson &Johnson yields a volatility of 13.7% and a beta of 0.54. Which stock carries more total risk? Which has more market risk? If the risk-free interest rate is 4% and you estimate the markets expected return to be 12%, calculate the equity cost of capital for Wal-Mart and Johnson & Johnson. Which company has a higher cost of equity capital?

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12.2 The Market Portfolio

Constructing the market portfolio 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

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Market Indexes
Report the value of a particular portfolio of securities. Examples: S&P 500, Wilshire 5000, Dow Jones Industrial Average (DJIA) Index funds Exchange-traded funds (ETFs)

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The Market Risk Premium

Determining the Risk-Free Rate The yield on U.S. Treasury securities 10 to 30 year treasuries The Historical Risk Premium Estimate the risk premium (E[RMkt]-rf)
Table 12.1 Historical Excess Returns of the S&P 500 Compared to One-Year and Ten-Year U.S. Treasury Securities

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The Market Risk Premium (contd)

A fundamental approach
Using historical data has two drawbacks: One alternative is to solve for the discount rate that is consistent with the current level of the index.
rMkt Div1 g Dividend Yield Expected Dividend Growth Rate P0

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12.3 Beta Estimation

Estimating Beta from Historical Returns Consider Cisco Systems stock and how it changes with the market portfolio.
Figure 12.1 Monthly Returns for Cisco Stock and for the S&P 500, 1996 2009

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Figure 12.2 Scatterplot of Monthly Excess Returns for Cisco Versus the S&P 500, 1996 2009
We can see that a 10% change in the markets return corresponds to about a 20% change in Ciscos return. So Ciscos beta is about 2! Beta corresponds to the slope of the best-fitting line in the plot of the securitys excess returns versus the market excess return.

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Using Linear Regression

Since E[i] = 0:

E[Ri ] rf i ( E[RMkt ] rf )
Expected return for i from the SML

i
Distance above / below the SML

i represents a risk-adjusted performance measure for the historical returns.

If i is positive, the stock has performed better than predicted by the CAPM. If i is negative, the stocks historical return is below the SML.

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Example 12.2
Suppose the risk-free interest rate is 4%, and the market risk premium is 6%. What range for Apples equity cost of capital is consistent with the 95% confidence interval for its beta?

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12.4 The Debt Cost of Capital

Debt Yields - Yield to maturity
Consider a one-year bond with YTM of y. For each $1 invested in the bond today, the issuer promises to pay $(1+y) in one year. Suppose the bond will default with probability p, in which case bond holders receive only $(1+y-L), where L is the expected loss per $1 of debt in the event of default. So the expected return of the bond is: rd = (1-p)y + p(y-L) = y - pL = Yield to Maturity Prob(default) X Expected Loss Rate
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Table 12.2 Annual Default Rates by Debt Rating (19832008)

The average loss rate for unsecured debt is 60%. 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.

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12.4 The Debt Cost of Capital (contd)

Debt Betas Alternatively, we can estimate the debt cost of capital using the CAPM. One approximation is to use estimates of betas of bond indices by rating category.
Table 12.3 Average Debt Betas by Rating and Maturity

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12.5 A Projects Cost of Capital

Asset (unlevered) cost of capital Expected return required by investors to hold the firms underlying assets. Weighted average of the firms equity and debt costs of capital

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

Asset (unlevered) beta

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