This page is a parent page for detailed discussion of issues associated with equity cost and the capital asset pricing model. Working through the details of cost of capital is useful if for no other reason to illustrate remarkable flaws in financial theory and the manner in which various parameters are estimated. You probably learned about the capital asset pricing formula somewhere along the way and you may even know that its authors won the Nobel Prize. After you are finished with university, it is very doubtful that you keep much interest in theoretical issues related to using betas, the equitry market risk premium and other CAPM issues. However, the required return on projecs and using the weighted average cost of capital will probably be important issues. Your investment bank may have standard WACC that they apply. You may be given a CAPM framework to plug in. You may get some country risk premiums from a horrible horrible website that lists them. This is how my life worked after university a very long time ago and I doubt things have changed much. But the older I get the more I keep coming back to nagging cost of capital issues. That is why have spent time creating this page and documenting different alternatives to the cost of capital.
If for some reason you are involved in estimating the cost of capital, you should become very frustrated. In the subsequent pages I will demonstrate that coming up with a cost of capital number can drive you crazy from both a theoretical and a practical data standpoint. Some of the difficult technical questions include: is there a risk premium for stocks versus risk free bonds (the EMRP) that is stable; in the case of non-U.S. companies, should the beta measured against a local index be used in risk analysis or an should international companies be the independent variable; how should the country risk be computed when local companies borrow at a lower rate than the soverign borrowing rate; can a good alternative to the CAPM be developed from implied cost of capital inside cash flow forecasts; how can the cost of capital for different types of projects be evaluated when there is no reasonable comparative market data.
The only way to really find the cost of capital is to ask industry participants what return they need in order to invest in real projects (before they will walk away). Even if participants have estimates that appear to be counter to data on betas, market premiums or other factors that may seem irrational in the context of financial theory, it is the point at which investors will not make investments that we are looking for when we measure cost of capital. As such, if you can interview people who work on real projects to gain an understanding of their minimum hurdle rate which is the definition of the cost of capital. While the comments and estimates are sometimes crude and extreme – for example, one country is very risky – the comments assist in a deriving a general order of magnitude that is reasonable for NEPRA’s process of setting the cost of capital.
I emphasise that caution should be taken in these industry participants as the most fundamental objective of any business is to earn a return above the cost of capital and they have a strong incentive to overstate their hurdle rate.
Valuation Fundamentals and Earning Returns above the Cost of Capital and Value
The most fundamental objective of corporations that do not earn a guaranteed return is to gain revenues above their costs where the costs include cost of capital on an investment. For a start-up company this assessment of revenues versus costs can involve making a relatively simple assessment of the probability selling to a larger company or the evaluation of costs and benefits may be a company bidding on solar project. However, for regulated companies with assured returns it has long been a principal that companies cover their costs including the cost of capital and not earn returns above the cost of capital.