230 CHAPTER 6 The Cost of Capital
faced with the task of estimating a company’s cost of equity, we generally use all three
methods and then choose among them on the basis of our confidence in the data used
for each in the specific case at hand.What are the two sources of equity capital?
Why do most established firms not issue additional shares of common equity?
Explain why there is a cost to using retained earnings; that is, why aren’t retained
earnings a free source of capital?The CAPM Approach
To estimate the cost of common stock using the Capital Asset Pricing Model (CAPM)
as discussed in Chapter 3, we proceed as follows:
Step 1. Estimate the risk-free rate, rRF.
Step 2. Estimate the current expected market risk premium, RPM.^6
Step 3. Estimate the stock’s beta coefficient, bi, and use it as an index of the stock’s
risk. The i signifies the ith company’s beta.
Step 4. Substitute the preceding values into the CAPM equation to estimate the re-
quired rate of return on the stock in question:
rsrRF(RPM)bi. (6-3)
Equation 6-3 shows that the CAPM estimate of rsbegins with the risk-free rate, rRF,
to which is added a risk premium set equal to the risk premium on the market, RPM,
scaled up or down to reflect the particular stock’s risk as measured by its beta coeffi-
cient. The following sections explain how to implement the four-step process.Estimating the Risk-Free Rate
The starting point for the CAPM cost of equity estimate is rRF, the risk-free rate.
There is really no such thing as a truly riskless asset in the U.S. economy. Treasury
securities are essentially free of default risk, but nonindexed long-term T-bonds will
suffer capital losses if interest rates rise, and a portfolio of short-term T-bills will pro-
vide a volatile earnings stream because the rate earned on T-bills varies over time.
Since we cannot in practice find a truly riskless rate upon which to base the
CAPM, what rate should we use? A recent survey of highly regarded companies shows
that about two-thirds of the companies use the rate on long-term Treasury bonds.^7
We agree with their choice, and here are our reasons:- Common stocks are long-term securities, and although a particular stockholder
may not have a long investment horizon, most stockholders do invest on a long-
term basis. Therefore, it is reasonable to think that stock returns embody long-
term inflation expectations similar to those reflected in bonds rather than the
short-term expectations in bills.
(^6) Recall from Chapter 3 that the market risk premium is the expected market return minus the risk-free rate.
(^7) See Robert F. Bruner, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins, “Best Practices in Es-
timating the Cost of Capital: Survey and Synthesis,” Financial Practice and Education, Spring/Summer 1998,
13–28.