Chapter 3

The Equity Premium and the Cost of Capital

3.1 ESTIMATING THE COST OF CAPITAL

In this chapter, we study how to estimate the components of the cost of capital: the cost of equity and the cost of debt. These are the opportunity costs of the providers of capital to the firm, measured by the return they can attain investing their funds in alternative assets of equivalent risk. The costs of equity, debt, and hybrid combinations of debt and equity are considered.

The cost of equity of a corporation is one of the fundamental concepts of corporate finance and an essential input to most practical valuation problems. In spite of considerable research, the cost of equity remains a most elusive quantity. In fact, several approaches have been proposed to estimate the cost of equity and the implementation of each of them varies widely in practice. In Section 3.2, we evaluate some of the proposed approaches and put forward guidelines for the estimation of the cost of equity. The main problem in estimating the cost of equity is agreeing on the proper risk premium, also called equity premium that investors demand for holding equity instead of government bonds. Since this is a controversial subject we discuss the several approaches to estimating the equity premium in some detail, perhaps more than the reader may want to consider at this point. We conclude that the cost of equity is not as high as simple analysis of the historical record would suggest. We show that the historical record, ...

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