Banking Chapter 12 Estimating The Cost Capital Outline The Following Outline Correlated

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Chapter 12

Estimating the Cost of Capital

I. Chapter Outline

The following chapter outline is correlated to the PowerPoint Lecture Slides. The PowerPoint slides

are referenced in bold. Alternative Examples to selected textbook examples are also available in the

PowerPoint Lecture Slides and are also referenced in bold.

12.1 The Equity Cost of Capital (Slide 7)

• Example 12.1 Computing the Equity Cost of Capital (Slides 8–9)

• PowerPoint Alternative Example 12.1 (Slides 10–13)

12.2 The Market Portfolio (Slide 14–16, 19)

• Examples of Market Indexes (Slide 17)

– Investing in a Market Index (Slide 18)

• The Market Risk Premium (Slides 20–22)

– Determining the Risk-Free Rate (Slide 20)

– The Historical Risk Premium (Slide 20)

• Table 12.1 Historical Excess Returns of the S&P 500 Compared to One-Year and Ten-

Year U.S. Treasury Securities (Slide 21)

– A Fundamental Approach (Slide 22)

12.3 Beta Estimation (Slide 23–27)

• Using Historical Returns (Slide 23–27)

• Figure 12.1 Monthly Returns for Cisco Stock and for the S&P 500, 1996-2009 (Slide 24)

12.4 The Debt Cost of Capital (Slides 35–40)

• Debt Yields Versus Returns (Slide 35)

• Common Mistake: Using the Debt Yield as Its Cost of Capital

12.5 A Project’s Cost of Capital (Slides 47–52)

• All-Equity Comparables (Slide 47)

• Figure 12.3 Using a Levered Firm as a Comparable for a Project’s Risk (Slide 48)

• Example 12.4 Estimating the Beta of a Project from a Single-Product Firm (Slides 49–50)

• Levered Firms as Comparables (Slide 47)

• The Unlevered Cost of Capital (Slides 51–52)

– Unlevered Beta

• Example 12.5 Unlevering the Cost of Capital (Slides 53–54)

– Cash and Net Debt (Slide 55)

• Example 12.6 Cash and Beta (Slides 56–57)

12.6 Project Risk Characteristics and Financing (Slides 64–66)

• Differences in Project Risk (Slides 64)

• Example 12.8 Operating Leverage and Beta (Slides 67–68)

• Common Mistake: Adjusting for Execution Risk

• Financing and the Weighted Average Cost of Capital (Slides 69–71)

– Perfect Capital Markets (Slide 69)

– Taxes–A Big Imperfection (Slide 69)

– The Weighted Average Cost of Capital (Slide 70)

• Interview with Shelagh Glaser

• Common Mistake: Using a Single Cost of Capital in Multi-Divisional Firms

12.7 Final Thoughts on Using the CAPM (Slides 77–78)

Chapter 12 Appendix: Practical Considerations When Forecasting Beta (Slides 84–90)

• Time Horizon (Slide 84)

• The Market Proxy (Slide 84)

Berk/DeMarzo

• Corporate Finance, Fourth Edition, Global Edition 53

II. Learning Objectives

12-1 Estimate a company’s cost of capital using the CAPM equation for the Security Market Line.

12-3 Discuss the attributes of a value-weighted portfolio.

12-5 Define alpha and beta and explain how they are generally estimated.

12-7 Estimate the cost of debt, given a company’s yield to maturity, probability of default, and

expected loss rate.

12-9 Calculate the cost of debt given a company’s debt beta, the risk free rate, and the market risk

premium.

12-11 Discuss the advantages of using several companies’ betas to estimate a project beta.

12-13 Calculate the weighted average cost of capital.

12-14 Discuss strengths and weaknesses of the CAPM.

III. Chapter Overview

12.1 The Equity Cost of Capital

This section reviews the use of the CAPM’s SML for cost of equity estimation. Example 12.1 shows

12.2 The Market Portfolio

This section shows how a value-weighted portfolio is constructed and describes common market

12.3 Beta Estimation

This section describes the use of historical returns to calculate beta. Figure 12.1 shows monthly

12.4 The Debt Cost of Capital

This section discusses main methods for estimating debt cost of capital. The most common method

12.5 A Project’s Cost of Capital

Calculating the project cost of capital can be done using all-equity comparable firms (Example 12.4)

or by using levered firms and removing the effects of leverage to arrive at the asset beta. The

12.6 Project Risk Characteristics and Financing

This section of the chapter discusses the differences in market risk across projects within a firm due to

12.7 Final Thoughts on Using the CAPM

The CAPM uses several assumptions and approximations. This section discusses its reliability. The

authors offer several thoughts on this. First, the types of approximations used to estimate cost of

capital are the same as those used to estimate cash flows but have far less impact on project value

than errors in the estimates used for cash flows. Second, the CAPM is practical, straightforward, and

Chapter 12 Appendix: Practical Considerations When Forecasting Beta

The Appendix discusses some practical issues about beta calculation, such as choosing a market

proxy and the time interval to use for estimation. It introduces a common method for adjusting beta,

as well as discussing treatment of outliers. Finally, the authors discuss the concept that firm

conditions and betas may change over time.

IV. Spreadsheet Solutions in Excel

The following Problems for Chapter 12 have spreadsheet versions of the problems available: 4, 11,

12, and 13.

These spreadsheets can be downloaded from the Instructor’s Resource Center at: