110 Corporate Finance
specific to the project in question. The methodology for estimating pure play betas and making appropriate
adjustments for leverage will be introduced at a later stage.
The cost of equity can be estimated in three ways:
- The CAPM approach
- Dividend discount model
- Risk premium approach
CAPM is the most widely used method.
The systematic risk of a stock, among other factors, depends on operating and financial leverage. The
higher the leverage, the higher is the beta.
The weighted average cost of capital is the hurdle rate for an average risk project undertaken by the
company. It can be applied only if the project is a mirror image of the company’s activities. Any project
which deviates from the parent’s operating and financial characteristics should be subjected to a different
hurdle rate. WACC is a meaningless concept for well diversified groups like the Tata group or the Birla
group.
The hurdle rate is the minimum return a project should earn to satisfy the investors expectations.
REFERENCES AND SUGGESTED READING
Booth, Laurence (1998). ‘A New Model for Estimating Risk Premiums’, Journal of Applied Corporate Finance, Spring.
——— (1999). ‘Estimating the Equity Risk Premium and Equity Costs: New Ways of Looking at Old Data’, Journal of
Applied Corporate Finance, Spring.
Bower, R S and Jeffrey M Jenks (1975). ‘Divisional Screening Rates’, Financial Management, Autumn.
Brigham, Eugene (1975). ‘Hurdle Rates for Screening Capital Expenditure Proposals’, Financial Management, Autumn.
Brigham, Eugene, Dilip K Shome, and Steve R Winson (1985). ‘The Risk Premium Approach to Measuring a Utility’s Cost
of Equity’, Financial Management, Spring.
Chambers, Donald R, Robert S Harris, and John J Pringle (1982). ‘Treatment of Financing Mix in Analyzing Investment
Opportunities’, Financial Management, Summer, pp. 24–41.
Conine, Thomas E and Maurry Tamarkin (1985). ‘Divisional Cost of Capital Estimation: Adjusting for Leverage’, Financial
Management, Spring, p. 54.
Erhardt, M C (1994). The Search for Value: Measuring the Company’s Cost of Capital, Harvard Business School Press.
Fuller, Russel Jr. and Halbert S Kerr (1981). ‘Estimating the Divisional Cost of Capital: An Analysis of Pure Play Technique’,
Journal of Finance, Dec.
Fuller, Russel Jr. and Kent Hickman (1991). ‘A Note on Estimating the Historical Risk Premium’, Financial Practice and
Education, Vol. 1, No. 2.
Gitman, L J and J R Forrester Jr. (1977). ‘A Survey of Capital Budgeting Techniques used by Major US Firms’, Financial
Management, Fall.
Gitman, Lawrence and Vincent A Mercurio (1982). ‘Cost of Capital Techniques Used by Major US Firms: Survey and Analysis
of Fortune 1000’, Financial Management, Spring.
Graham, John R and Campbell Harvey (2001). ‘The Theory and Practice of Corporate Finance: Evidence from the Field’,
Journal of Financial Economics, Vol. 61.
Gordon, M J and Paul Halpern (1972). ‘The Cost of Capital for a Division of a Firm’, Journal of Finance, May.
Gup, Benton and Samuel Norwood (1982). ‘Divisional Cost of Capital: A Practical Approach’, Financial Management, Spring.
Hamada, R S (1972). ‘The Effect of the Firm’s Capital Structure on the Systematic Risk of Common Stocks’, Journal of
Finance, Vol. 27, No. 2, pp. 435–52.
Harrington, Diana (1984). Modern Portfolio theory and Capital Asset Pricing Model, Prentice-Hall Inc., Englewood Cliffs,
New Jersey.