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VOL.5 NO.3
Spring
2004
Cost of Capital
B Y M I C H A E L S . PA G A N O , P H . D . , C FA , AND D AV I D E . S T O U T, P H . D .
FOR MICROSOFT AND GENERAL ELECTRIC PRODUCE DIFFERENT RESULTS FOR EACH FIRM.
he idea of the “cost of capital” is fundamen- various assumptions and practical choices. Conventional
There is considerable debate about the appropriate many situations where uncertainty exists, the analyst
forward-looking U.S. market risk premium to use for must rely on his or her best judgment and also perform
capital budgeting, investment planning, and other sensitivity analyses to help quantify the impact of dif-
financial decisions. Financial economists Robert Shiller ferent assumptions on the output of whatever decision
and Roger Ibbotson examined the same set of historical model is being used.
data to determine current expectations for the market Table 1 presents some possible alternative combina-
risk premium, and they both came up with different tions of assumptions related to an analyst’s choice of
answers.16 One suggests that the market risk premium market risk premium and risk-free rate. We use three
in the U.S. is no more than 2% per annum while the sets of estimates for the risk-free rate (i.e., the approxi-
other expects an average of 4% for the market risk pre- mate levels of the one-month, five-year, and 10-year
mium as we progress in the early 21st century. Indeed, U.S. Treasury securities) and three different expected
both of these figures are lower than the historical aver- market risk premiums (based on the two TIAA-CREF
age U.S. risk premium of 6% to 8% that academic analysts’ estimates and a higher estimate of 6% based
researchers have calculated and reported. on historical experience). As can be seen from the
There also is no consensus about which maturity of results of using just one asset-pricing model (the adjust-
U.S. Treasury securities is appropriate for estimating a ed-beta CAPM), a firm’s estimated Ks can vary substan-
risk-free rate, Krf, within the CAPM framework.17 For tially. For example, Microsoft’s estimated cost of equity
example, finance textbooks typically use the yield on a can vary from a low of 4.0% to a maximum of 13.9%
short-term U.S. Treasury security such as a one-month, depending on the particular combination of risk-free
three-month, or one-year T-bill, while many corporate rate and expected market risk premium. Likewise,
practitioners use yields on longer-term instruments, GE’s estimated cost of equity also varies considerably,
such as five- or 10-year Treasury notes, in order to although less than Microsoft’s because of GE’s lower
match more closely the time horizon associated with adjusted-beta estimate of 1.08 versus Microsoft’s 1.48.
long-term investment projects.18 Using the APM approach, one can simply repeat the
So, which estimates should be used? As is typical in steps for the CAPM except that the regression now