This chapter explains the process of estimating discount rates, by relating them to the risk and return models described in the previous chapter -

• The cost of equity can be estimated using risk and return models -- the capital asset pricing model, where risk is measured relative to a single market factor, the arbitrage pricing model, where the cost of equity is determined by the sensitivity to multiple unspecified economic factors or a multiple factor model, where sensitivity to macro-economic variables is used to measure risk.

63 All of the capital ratios that govern banks are stated in terms of book value of equity, though equity is defined broadly to include preferred stock.

• In both these models, the key inputs are the riskfree rate, the risk premiums and the beta (in the CAPM) or betas (in the APM). The last of these inputs is usually estimated using historical data on prices; in the case of private firms, they might have to be estimated using comparable publicly traded firms.

• While the betas are estimated using historical data, they are determined by the fundamental decisions that a firm makes on its business mix, its operating and financial leverage.

• 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. The cost of debt is the market rate at which the firm can borrow, adjusted for any tax advantages of borrowing. The cost of preferred stock, on the other hand, is the preferred dividend.

• The cost of capital is the minimum acceptable hurdle rate that will be used to determine whether to invest in a project.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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