Fin 449

Teaching Note Cost of Capital

Prof. Rogers
One should always recall that the cost of a firms capital reflects the rate of return
required by the firms investors. Given that investment in any firm is a risky venture
(regardless of whether the investment is in the form of debt, equity, or hybrid type of
financing), we can always view the firms cost of capital as reflected by the following
basic relation:
Cost of capital = risk-free rate + firm-specific risk premium
During this weeks class sessions, I plan to focus on practical issues in estimation of an
individual firms cost of capital. The standard formula for a firms cost of capital is
expressed as the weighted average cost of capital (WACC).
WACC = wdkd(1-t) + weke + wpskps
Where the d subscript denotes debt, the e subscript denotes equity, and the ps
subscript denotes preferred stock. The w variables indicate the market value
weights of debt, equity, and preferred stock, respectively. Given the relatively
small role of preferred stock in most corporate capital structures, we will not use
class time to discuss this form of capital. However, this does not excuse you from
dealing with it if you encounter a firm with preferred stock in its capital structure.
The WACC formula states that the rate of return required by the firms investors reflects a
weighted average of the rates of return required by the various classes of investors in the
firm. The weights used reflect the proportions of each type of capital supplied by the
firms investors (i.e., if the firm is heavily leveraged, the cost of debt is given a larger
weight).
We will utilize the framework of the weighted average cost of capital to discuss in turn
1)
2)
3)

cost of equity, ke
cost of debt, kd, and
market value weights

We will spend most of the week discussing issues surrounding cost of equity because
1) Large gaps exist between theory and practice in estimating the cost of equity, and
2) For many firms, equity composes the majority of its capital.

Cost of Equity
Most of our discussion will focus upon the use of the capital asset pricing model
(CAPM). The CAPM states that the cost of a firms equity capital is equal to the risk-free
rate plus a firm-specific risk premium that is equal to the firms risk relative to the
market portfolio multiplied by the difference between the expected return on the
market portfolio and the risk-free rate.
ke,i = rf + i (rm rf)
The beta term above, i, is a measure that reflects the riskiness of the individual firms
(firm i) stock relative to the market as a whole. The term in parentheses is typically
referred to as the market risk premium (or equity risk premium).
The CAPM provides a convenient formulation for calculating the cost of equity.
However, in some respects, it is too convenient. In introductory (and often many other)
finance courses, estimation of cost of equity becomes a simple homework (or exam)
question where all of the inputs are given to you. In practice, the estimation of a firms
current cost of equity is not remotely this convenient.
The Issues
1) What is the maturity of the risk-free rate that should be used (i.e., 3-month, 1year, 10-year, 30-year)?
2) How large is the market risk premium?
3) Does the market risk premium change over time (i.e., do market conditions
change the premium)?
4) How do we measure beta?
During class, Ill discuss each of these issues, and well examine some real data to gain
some insight as to what difficulties may occur.
Issue 1: maturity of risk-free rate
The nature of the capital budgeting analysis should drive the choice. Specifically, if the
firm is deriving a cost of capital to evaluate an investment opportunity that will generate
cash flows over a short time horizon, then a short-term rate should be chosen. For the
purpose of our company analyses, we are planning to value equity. Thus, we will be
discounting cash flows expected to occur far into the future. Thus, this implies that for
such analysis, we would prefer to use a long-term government rate.
Issue 2: how large is the market risk premium?
Fundamentally, the market risk premium is measured as the difference between the
returns on a large index of stocks and risk-free returns. Ibbotson Associates tracks the
difference between large stock indices and various government rates annually (their

results are published in an annual volume called Stocks, Bonds, Bills, and Inflation that is
typically available in the library). A small portion of comparable data is available at
www.stern.nyu.edu/~adamodar. In class, we will discuss the historical premiums. Two
basic issues exist:
1) Should market returns be compared to short-term or long-term Treasury rates?
2) What method of averaging should be used (arithmetic or geometric)?
The first issue is simply a function of the type of capital budgeting analysis for which the
cost of capital is being computed (as in Issue 1 regarding the choice of risk-free rate
above). The use of the short-term Treasury rates is appropriate if the premium is used to
evaluate a short-term project. This line of reasoning is reversed if evaluating a long-term
project. Thus, larger risk premiums are typically used for short-term project analysis (if
the term structure of government rates is upward sloping), as opposed to smaller risk
premiums for long-term projects. These are offset by the use of a lower risk-free rate for
short-term projects, and a higher risk-free rate for long-term projects.
The second issue fundamentally asks the question, what should be investors best guess
regarding the difference between stock market returns and Treasury rates for any given
year. The answer is:
Arithmetic average, BUT only if returns are uncorrelated across time.
Unfortunately, this condition is not true. Returns are negatively correlated across time.
This fact implies that the arithmetic average overstates the true average of returns.
What does the geometric average represent? The average return (compounded annually)
from a buy and hold type of investment strategy is the correct answer. So, the
geometric average annual stock returns minus the geometric average of annual Treasury
returns reflect the historic premium. As long as you believe that investors use relatively
long holding periods for investments in stocks and Treasurys, the geometric average may
provide a better historic estimate.
Issue 3: does the market risk premium change over time?
Until the 1990s bull market, it was fairly unquestioned that the market risk premium was
reflected by the historic risk premium. However, one noteworthy question to ask is how
long of a time period should one compute the average? The Ibbotson data that is
commonly used in the US reflects stock returns from 1926 forward. However, is this time
period an accurate depiction of the expected risk premium? There is evidence that the risk
premium was considerably lower during the 1800s. Considerable theoretical work in
economics has suggested that the historic risk premiums commonly used are much too
high.
In response to these issues, a number of financial and accounting research professors
have been developing models that utilize current price data to infer the level of the
market risk premium. The basic methodology is to use current market price, expected
future dividends (or alternatively, cash flow), and find the internal rate of return (IRR)

implied by the price and future cash flows. This internal rate of return reflects the rate of
return required by investors to make the current market price fair (i.e., zero NPV). By
deducting a Treasury rate from this implied rate of return, we obtain an implied risk
premium.
In class, we will look at Damodarans annual implied risk premium calculations. The
most interesting aspect of his implied risk premiums is that the figures are typically much
lower than historic premiums. Second, the premiums tend to be a function of market
direction. When the market is trending higher, the risk premium is declining. Finally, this
market premium gives us some sense of the markets mood. When investors are
optimistic about future growth, this fact likely implies a lower risk premium.
Issue 4: measurement of beta
Beta (), in the context of the CAPM, is a measure of a stocks systematic risk.
Specifically, it measures the risk of holding a stock as part of a market portfolio of
assets. In technical terms, beta is found by calculating a time-series regression of the
following form:
Return on stock (or portfolio) i = intercept term + i (Return on market portfolio) + i
The beta term in the above regression reflects the relation between the market portfolio
and the stock of interest. This sounds easy enough! However, several practical issues
complicate the measurement of beta.
Issues Complicating Measurement of Beta
1)
2)
3)
4)
5)

What is the market portfolio?

How many observations of returns are needed?
Whats the time frame of returns?
How large is the estimation error of beta?
What if the beta used yields an unreasonable cost of equity estimate?

Issue 1: The market portfolio

In the context of the CAPM, the market portfolio is meant to be a portfolio of all assets,
stocks, bonds, real estate, human capital, etc. However, to operationalize the model, we
must know the return on the market portfolio. This requires observable prices.
Unfortunately, the only market with adequate transparency in prices is the stock market.
So, the CAPM has been built around explaining returns on stocks. So, what are the
common market portfolios used in calculating beta? Any large, diversified portfolio may
be used as the market portfolio in the regression. For example, the betas reported in
Yahoo Finance utilize the S&P 500 as the market portfolio.
Issue 2: Number of observations

During our class discussion of historical market risk premium calcations, I mentioned
during the computation of the market risk premium more data is generally better. Does
this same concept apply in the calculation of the beta? No. Individual firms are expected
to change and evolve over time with respect to risk. Thus, we need to use a sufficient
number of observations to generate a good estimate, but want to avoid using data that is
no longer relevant. Typical practice is to use 60 or more observations. This leads to the
next issue.
Issue 3: Whats the return time frame used?
Most calculations involve monthly returns. I have also seen calculations using weekly,
even daily, returns. The weakness with shorter and shorter time horizons is that they tend
to introduce more noise into the estimation. Its typically not feasible to use time
frames longer than monthly because then we would have to go far back into the past to
obtain enough observations. Using 60 months of returns requires one to use 5 years of
history. This is appropriate if we can safely assume that the firms risk profile has not
materially changed during this time frame. For many firms, this is a reasonable
assumption. Nevertheless, it is worthwhile to ask yourself, has the firms risk profile
fundamentally changed during this time frame?
Issue 4: How large is the estimation error?
In calculating beta, one should recognize that it is an estimate. Therefore, beta is subject
to estimation error. This estimation error is reflected by the standard error of the beta
coefficient. The standard error can help us understand the possible range containing the
true beta. For example, suppose you run a regression to find a beta. The beta estimate
equals 0.85. If the standard error is 0.30, then the true beta lies in the range of 0.55
1.15 (plus or minus 1 standard error) with approximately 68% probability and lies in the
range of 0.25 1.45 (reflects 2 standard errors) with approximately 95% probability.
Estimation error can be a significant source of potential error in beta measurements. One
way of obtaining a beta estimate with lower standard error is through the bottom-up
approach explained later in this note.
Issue 5: What if the measured beta yields an unreasonable cost of equity estimate?
This is an important issue, and is not well addressed in any book of which I am aware. In
particular, I occasionally run across cases where the cost of equity estimate is below the
same firms cost of debt estimate. In such cases, I am always concerned that equity risk
(i.e., beta) is underestimated. I often find the bottom-up beta calculation discussed below
yields a higher beta estimate for these types of situations.
The Bottom-up beta approach

One major objection to beta estimates obtained by regression (explained above) is the
large estimation error. One approach that reduces this problem is a bottom-up approach.
Ill outline the basic approach below.
1) Obtain beta estimates from companies that should be of similar business risk. The
typical approach is to use a set of firms from the same industry.
2) Use the average industry beta, L, to find the companys unlevered beta, u..
L
D
u =
1 (1 t )
E
Ideally the unlevering uses the industry market value of debt as D and
industry market value of equity as E. In the data provided by
Damodaran, the debt-to-equity ratio used reflects the book values of
interest-bearing debt and the market values of common equity in each
industry. Of course, the tax rate, t, is also based on the industry average.
3) Calculate the beta of the firms stock by levering the unlevered industry beta.
L = u [1 (1 t )

D
]
E

Remember that you are now calculating a beta for the company, so t,
D, and E all have to be specific to the company for which you are
estimating beta!
To be consistent with the bullet point listed under 2), the levering needs to
use the same definitions of debt and equity as used in the unlevering
process (i.e., use book value of interest-bearing debt and market value of
common equity).
The debt and equity values should be calculated as of the same point in
time.
4) If the firm operates in multiple industry segments, you should calculate an
unlevered beta for each segment. The firms levered beta is then a weighted
average of the segment unlevered betas levered using the companys debt-toequity ratio.
The basic advantage of the bottom-up approach is that it provides an estimate with lower
standard error. Additionally, this approach utilizes current information about the firms
financial leverage. To the degree that financial leverage changes through time, the firms
beta should change as well. The bottom-up approach is able to take this into account.
Finally, a bottom-up beta can be calculated for the equity of firms that do not have
publicly traded stock.
The downside to the bottom-up approach is that we must identify comparable firms. To
the degree that many firms differentiate themselves in such ways that business risk is not
directly comparable, we may make some questionable comparisons.
Cost of Debt

The cost of a firms debt is simply the interest rate required to compensate lenders for the
firms default risk. In BA 303, you should have learned that the yield to maturity (YTM)
of a firms bonds reflects the current level of this rate (for non-callable bonds). So,
finding cost of debt (before tax) is simply a function of finding YTM on the firms bonds,
right? If only it was always so simple!
Relatively few firms have issued publicly traded bonds. And, even if they have, bond
price data is substantially limited.
Thus, its useful to recall that a companys cost of debt can be thought of as follows:
Cost of debt (before-tax) = risk-free rate + firm-specific risk premium
The issues to address here are:
1) The risk-free rate does not specify a maturity. Some firms may typically issue
short-term debt while others typically use very long-term debt. As such the choice
as to whether to use a short-term Treasury rate (i.e., 1-year) or a long-term rate
(i.e., 10 or 30 years) depends on the companys typical maturity for new issues
of debt. In class, well go through an estimation process using a companys
footnote data on debt to calculate a weighted average maturity. Typically, this
process will yield a lower bound on the appropriate maturity to use for the riskfree rate.
2) The firm-specific risk premium reflects the markets assessment of the necessary
return required to lenders because of the firms default risk. For example, if a
business asks for a 10-year loan, and the lender asks for an interest rate of 8%
when the 10-year Treasury rate is 3%, then the lender is adding a 5% risk
premium (or spread) to compensate for the borrowers risk of defaulting on the
loan. Companies that issue debt to the public will typically pay one or more bond
rating agencies to rate the companys debt (in general) as well as specific bond
issues. In many cases, we can get a good idea as to the default risk premium
appropriate for a company by knowing its credit rating.
3) Sources for credit ratings:
Standard & Poors (www.standardandpoors.com) and Moodys
(www.moodys.com) are the biggest US rating agencies. If you register on
their websites, you can search for up-to-date credit ratings. Alternatively,
you can find the Standard & Poors issuer credit rating for your company
by using Report Assistant in Research Insight (as of the month of the most
recent data update). The data item in Research Insight is Domestic LT
ICR/S&P. Youll need to click on Definition to see how the number
shown for the data item translates into the S&P rating.
Source
for default risk premiums:
4)
* On www.bondsonline.com, click on Todays Market then Composite Bond
Yields then see data. The third table of data shows current yields on corporate
bonds. The default risk premium for different maturity/rating classes is the difference
between the corporate yield and its underlying Treasury yield. For example, if I see
that the yield on 10-year AAA bonds is 5.07% and the yield on 10-year Treasury
bonds (first table) is 2.95%, then the default risk premium for 10-year AAA rated

companies is estimated as 2.12% (5.07% - 2.95%). For another view of how

corporate bond spreads are shown, click on US Corporate Bond Spreads. If you
scroll down the page, there is a sample table of default risk premiums by different
maturity/rating classes for Banking companies as of March 1, 2006. From this table, a
bank with S&P credit rating of A would pay 95 basis points (i.e., 0.95%) above the
10-year Treasury yield to borrow for 10 years. So, if the 10-year Treasury yield is 4%
and the companys default risk premium is 95 basis points, then the companys cost of
10-year debt is 4.95%.
Suppose your company does not have a credit rating? What are alternative approaches to
estimating the companys cost of debt?

Use Damodarans interest coverage ratio approach. Recall that interest

coverage ratio is equal to operating income divided by interest expense.
Damodaran mapped interest coverage ratios to credit ratings. Therefore,
depending on the range in which a companys interest coverage falls, we
could estimate its credit rating. In class, well go through an example of
Damodarans spreadsheet. NOTE: this exercise is not necessary IF the firm
has an actual credit rating.
Calculate the companys current average interest cost by dividing interest
expense by total interest-bearing liabilities. This method is not very
desireable, and should only be used when all other alternatives are fruitless.
The cost of debt is supposed to be a forward-looking estimate, not a reflection
of the firms average cost of existing debt.

A Final Note on the WACC (market value weights)

In the WACC specification, the weights to be used are based on market values. Because
market values of corporate debt are rarely available and such values are often close to
book value, the common approach to estimating market value weights for debt and equity
is:
wd = book value of debt (book value of debt + market value of equity)
we = market value of equity (book value of debt + market value of equity)
Market value of equity equals the stocks price per share multiplied by the number of
shares outstanding.
NOTE: if the firms capital structure includes preferred stock, its value should be
included in the denominator of each equation.
The market value weights are utilized as opposed to book values because new capital is
raised by issuing securities at current market prices.