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)
12.2 The Market Portfolio (Slide 14–16, 19)
• Constructing the Market Portfolio (Slides 14–16)
• Market Indexes (Slide 17)
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)
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)
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 53
II. Learning Objectives
12-2 Describe the market portfolio and how it is constructed in practice.
12-4 Describe common proxies for the market return and the risk-free rate.
12-6 Compare the use of average return versus beta and the SML to estimate cost of equity capital.
12-8 Discuss the difference between the yield to maturity and the cost of debt when there is low
versus high default risk.
12-10 Illustrate the use of comparable companies’ unlevered betas or unlevered cost of capital to
estimate project cost of capital.
12-12 Define operating leverage and discuss its influence on project risk.
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)
12.6 shows the effect of excess cash on the unlevered beta. A final way to estimate a project’s beta is
to use the industry-average asset beta.
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
Chapter 12 Appendix: Practical Considerations When Forecasting Beta
The Appendix discusses some practical issues about beta calculation, such as choosing a market
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: