pricing and multifactor models). We also present
three different waysin which we canestimate the
costofequity: byenteringtheparametersofa risk
and return model, by lookingat returndifferences
acrossstocksoverlongperiods,andbybackingout
an implied cost of equity from stock prices.- The cost of debt is the rate at which a firm can
borrowmoneytodayandwilldependonthedefault
riskembeddedinthefirm.This defaultriskcanbe
measuredusing abond rating(if oneexists) or by
looking at financial ratios. In addition, the tax
advantage thataccrues from tax-deductibleinterest
expenses will reduce the after-tax cost of borrowing.
Thecostofcapitalisaweightedaverageofthecostsofthe
differentcomponentsoffinancing,withtheweightsbasedon
the market values of each component.
1 It is true that founder/CEOssometimes own significant
amountsofstockinlargepubliclytradedfirms:LarryEllison
at Oracleand Bill Gates atMicrosoft aregood examples.
However, these insiders can almost never be marginal
investorsbecausetheyarerestrictedintheirtradingbothby
insidertradinglawsandbythedesiretomaintaincontrolin
their companies.
2 To see the intuitive basis for factor analysis, note that
marketriskaffectsallormostinvestmentsatthesametime.
Inafactoranalysis,wecombthroughhistoricaldatalooking
forcommonpatternsofpricemovements.Whenweidentify
eachonewecallitafactor.Theoutputfromfactoranalysis
includesthenumberofcommonpatterns(factors)thatwere