Damodaran on Valuation

2.4. CONCLUSION

This chapter explains the process of estimating discount rates by breaking down financing into debt and equity components, and discusses how best to estimate the costs of each:

• The cost of equity is difficult to estimate, partly because it is an implicit cost and partly because it varies across equity investors. For publicly traded firms, we estimate it from the perspective of the marginal investor in the equity, who we assume is well diversified. This assumption allows us to consider only the risk that cannot be diversified away as equity risk, and to measure it with a beta (in the capital asset pricing model) or betas (in the arbitrage pricing and multifactor models). We also present three different ways in which we can estimate the cost of equity: by entering the parameters of a risk and return model, by looking at return differences across stocks over long periods, and by backing out an implied cost of equity from stock prices.

• The cost of debt is the rate at which a firm can borrow money today and will depend on the default risk embedded in the firm. This default risk can be measured using a bond rating (if one exists) or by looking at financial ratios. In addition, the tax advantage that accrues from tax-deductible interest expenses will reduce the after-tax cost of borrowing.

The cost of capital is a weighted average of the costs of the different components of financing, with the weights based on the market values of each component.