Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition

CHAPTER 8

Estimating Risk Parameters and Costs of Financing

The preceding chapter laid the groundwork for estimating the costs of equity and capital for firms by looking at how best to estimate a riskless rate that operates as a base for all costs, an equity risk premium for estimating the cost of equity, and default spreads for estimating the cost of debt. It did not, however, consider how to estimate the risk parameters for individual firms. This chapter examines the process of estimating risk parameters for individual firms, for estimating both the cost of equity and the cost of debt.

For the cost of equity, we look at the standard process of estimating the beta for a firm and consider alternative approaches. For the cost of debt, we examine bond ratings as measures of default risk and the determinants of these ratings.

The chapter closes by bringing together the risk parameter estimates for individual firms and the economy-wide estimates of the risk-free rate and risk premiums to estimate a cost of capital for the firm. To do this, the sources of capital have to be weighted by their relative market values.

THE COST OF EQUITY AND CAPITAL

Firms raise money from both equity investors and lenders to fund investments. Both groups of investors make their investments expecting to make a return. Chapter 4 argued that the expected return for equity investors would include a premium for the equity risk in the investment. We label this expected return the cost of equity. Similarly, ...