304 Planning and Forecasting
where REis the return on the stock and also the cost of equity financing, Dis
the dollar amount of annual dividends per share paid by the firm to stockhold-
ers, P 0 is the stock price at the beginning of the year, and P 1 is the stock price
at the end of the year. For example, suppose the stock price is $100 per share at
the beginning of the year and $112 at the end of the year, and the dividend is
$8 per share. The stockholders would have earned a return of 20%, and this
20% is also the cost of equity financing:
The capital asset pricing model (CAPM) is often used to estimate a firm’s
cost of equity financing. The idea behind the CAPM is that the rate of return
demanded by equity investors will be a function of the risk of the equity,
where risk is measured by a variable beta (β).According to the CAPM, βand
cost of equity financing are related by the following equation:
where RFis a risk-free interest rate, such as a Treasury bill rate, and RMis the
expected return for the stock market as a whole. For example, suppose the ex-
pected annual return to the overall stock market is 12%, and the Treasury bill
rate is 4%. If a stock has a βof 2, then its cost of equity financing would be
20%, computed as follows:
Analysts often use the Standard & Poor ’s 500 stock portfolio as a proxy
for the entire stock market when estimating the expected market return. The
βs for publicly traded firms are available from a variety of sources, such as
Bloomberg, Standard & Poor ’s, or the many companies that provide equity re-
search reports. How βis computed and the theory behind the CAPM are be-
yond the scope of this chapter, but the textbooks listed in the bibliography to
this chapter provide excellent coverage.
Weighted Average Cost of Capital
Most firms use a combination of both equity and debt financing to raise money
for new projects. When financing comes from two sources, the appropriate dis-
count rate is an average of the two financing rates. If most of the financing is
debt, then debt should have greater weight in the average. Similarly, the weight
given to equity should ref lect how much of the financing is from equity. The
RE=+× − (^4) [] (^2) () 12 4 =20%%%%
RR RREF=+ −β()MF
RE=$$ $+−=
$
(^8112100) %
100
20
R
DP P
E P
+− 10
0