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Chapter 2 – ESTIMATING DISCOUNT RATES (starting at page 28)

Cost of Equity * Can be measured with: * CAPM: risk measured relative to a single market factor * Arbitrage pricing model: cost of equity is determined by the sensitivity to multiple unspecified economic factors * Multiple factor model: sensitivity to macroeconomic variables is used to measure risk i. Estimate Risk-Free Rate ii. Estimate Risk Premium iii. Estimate Beta * Unlevered beta: the beta a company would have if it were all equity financed * CAPM: beta estimated relative to market portfolio * APM / Multi-factor: betas relative to each factor have to be measured. There are 3 estimation approaches: * Historical market betas (most used): regressing stock returns against market returns. Analysts often obtain these from estimation services. * Fundamental betas (bottom-up): betas determined by (i) type of businesses the firm in is, (ii) degree of operating leverage (fixed costs relative to total costs), (iii) firm’s financial leverage. * Accounting betas: look at changes in the firms’ earnings vs. changes in earnings for the market. * For private firms, may have to estimate betas using comparable publicly traded firms. * Estimating the cost of equity * Cost of equity is the return shareholders expect to make. If firms don’t deliver this, the SHs become restive and rebellious. * CAPM: Expected return = riskfree rate + beta * expected risk premium * Cost of equity is usually much higher than the cost of debt
Cost of Capital * Weighted average of the costs of the different components of financing: debt, equity, hybrid securities. 3 evaluation approaches: * Unlevered cost of equity approach: cost of equity using an unlevered beta. *