Estimation Approaches
Aswithcostofequity,thereareanumberofdifferentwaysin
whichwecanestimatethecostsofcapital.Inthissubsection,
weconsiderthree:theunleveredcostofequityapproach,the
impliedrate of returnapproach, and theweighted average
cost approach.
Unlevered Cost of Equity
Earlierinthischapter,weconsideredtherelationshipbetween
equity betasand leverage and introduced thenotionof an
unleveredbeta(i.e.,thebetathatacompanywouldhaveitif
itwere allequityfinanced). Thecost ofequitythat would
resultfromusingan unleveredbetais calledtheunlevered
cost of equity:
Therearesomeanalystswhousetheunleveredcostofequity
asthecostofcapitalforafirm.Theirreasoningisbasedon
the argument made by Modigliani and Miller in their
pathbreaking paper on capital structure
43 thatthevalueofafirmshouldbeindependentofitscapital
structure.Ifweacceptthisproposition,itfollowsthatthecost
of capital for a firm should not change as its debt ratio
changes.Thecostofequity (andcapital)at 0 percent debt
should be the cost of capital at every other debt ratio.
Whileusingtheunleveredbetatoarriveatthecostofequity
has its conveniences, it does come with baggage. In
particular,thecostofcapitalmayverywellchangeasdebt
ratioschangein thepresenceoftaxesanddefaultrisk,and