1、1ESTIMATING RISK PARAMETERS AND COSTS OF FINANCING2Cost of Equity The cost of equity is the rate of return investors require on an equity investmentin a firm. Expected Return = Riskless rate + Beta (Risk Premium) This expected return to equity investors includes compensation for the market risk in t
2、he investment and is the cost of equity.3Betas In the CAPM, the beta of an investment is the risk that the investment adds to a market portfolio. In the APM and Multi-factor model, the betas of the investment relative to each factor have to be measured.4There are three approaches available for estim
3、ating these parameters.： The first is to use historical data on market prices for individual investments. The second is to estimate the betas from the fundamental characteristics of the investment. The third is to use accounting data.5Historical Market Betas The conventional approach for estimating
4、the beta of an investment is a regression of the historical returns on the investment against the historical returns on a market index. In theory, these stock returns on the assets should be related to returns on a market portfolio In practice, we tend to use a stock index, such as the S&P 500, as a
5、 proxy for the market portfolio, and we estimate betas for stocks against the index.6Regression Estimates of Betas The standard procedure for estimating betas is to regress stock returns (Rj) against market returns (Rm) Rj=a+bRm where a = Intercept from the regression b = Slope of the regression 7 T
6、he intercept of the regression provides a simple measure of performance of theinvestment during the period of the regression, when returns are measured against the expected returns from the capital asset pricing model. To see why, consider the following rearrangement of the capital asset pricing mod
7、el:8 Rj=Rf+Rm-Rf =Rf(1-)+Rm Compare this formulation of the return on an investment to the return equation from the regression: Rj=a+bRmThus, a comparison of the intercept (a) to Rf (1-b) should provide a measure of the stocks performance, at least relative to the capital asset pricing model .In sum
8、mary,then:If a Rf (1-b) . Stock did better than expected during regression period. a = Rf (1-b) . Stock did as well as expected during regression period. a 8.50 (12.50) AAA0.75%0.35%6.50 - 8.50 (9.5-12.5) AA1.00% 0.50%5.50 - 6.50 (7.5-9.5) A+1.50% 0.70%4.25 - 5.50 (6-7.5) A1.80% 0.85%3.00 - 4.25 (4.
9、5-6) A2.00% 1.00%2.50 - 3.00 (4-4.5) BBB2.25% 1.50%2.25- 2.50 (3.5-4) BB+2.75% 2.00%2.00 - 2.25 (3-3.5) BB3.50% 2.50%1.75 - 2.00 (2.5-3) B+4.75% 3.25%1.50 - 1.75 (2-2.5) B6.50% 4.00%1.25 - 1.50 (1.5-2) B 8.00% 6.00%0.80 - 1.25 (1.25-1.5) CCC10.00%8.00%0.65 - 0.80 (0.8-1.25) CC11.50%10.00%0.20 - 0.65
10、 (0.5-0.8) C12.70%12.00% 0.20 (0.5) D15.00%20.00%28Calculating the Cost of Hybrid SecuritiesCost of Preferred StockPreferred stock shares some of the characteristics of debt - the preferred dividend is pre-specified at the time of the issue and is paid out before common dividend and some of the char
11、acteristics of equity - the payments of preferred dividend are not tax deductible. If preferred stock is viewed as perpetual, the cost of preferred stock can be written as follows:KpsPreferred Dividend per shareMarket Price per preferred share29 In terms of risk, preferred stock is safer than common
12、 equity, because preferred dividends are paid before dividends on common equity. It is, however, riskier than debt since interest payments on debt are made prior to preferred dividend payments. Consequently, on a pre-tax basis, it should command a higher cost than debt and a lower cost than equity.3
13、0Calculating the Weights of Debt and Equity Components Now that we have the costs of debt, equity and hybrid securities, we have to estimate the weights that should be attached to each. Before we discuss how best to estimate weights, we define what we include in debt. We then make the argument that
14、weights used should be based upon market value and not book value.31What is debt? The answer to this question may seem obvious since the balance sheet for a firm shows the outstanding liabilities of a firm. There are, however, limitations with using these liabilities as debt in the cost of capital c
15、omputation. The first is that some of the liabilities on a firms balance sheet, such as accounts payable and supplier credit, are not interest bearing. Consequently, applying an after-tax cost of debt to these items can provide a misleading view of the true cost of capital for a firm. The second is
16、that there are items off the balance sheet that create fixed commitments for the firm and provide the same tax deductions that interest payments on debt do. The most prominent of these offbalance sheet items are operating leases.32Estimating the Cost of Capital Since a firm can raise its money from
17、three sources - equity, debt and preferredstock - the cost of capital is defined as the weighted average of each of these costs. The cost of equity (ke) reflects the riskiness of the equity investment in the firm, the after-tax cost of debt (kd) is a function of the default risk of the firm and the
18、cost of preferred stock (kps) is a function of its intermediate standing in terms of risk between debt and equity. The weights on each of these components should reflect their market value proportions since these proportions best measure how the existing firm is being financed. Thus if E, D and PS are the market values of equity, debt and preferred stock, respectively, the cost of capital can be written as follows:Cost of Capital= keE/(D+E+PS)+kdD/(D+E+PS)+kpsPS/(D+E+PS)
