Estimating the Cost of Equity

Having estimated the riskfree rate, the risk premium(s) and the beta(s), we can now estimate the expected return from investing in equity at any firm. In the CAPM, this expected return can be written as:

Expected Return = Riskfree Rate + Beta * Expected Risk Premium where the riskfree rate would be the rate on a long term government bond, the beta would be either the historical, fundamental or accounting betas described above and the risk premium would be either the historical premium or an implied premium.

In the arbitrage pricing and multi-factor model, the expected return would be written as follows:

Expected Return = Riskfree Rate + # !j * Risk Premiumj j-1

where the riskfree rate is the long term government bond rate, Pj is the beta relative to factor j, estimated using historical data or fundamentals, and Risk Premiumj is the risk premium relative to factor j, estimated using historical data.

The expected return on an equity investment in a firm, given its risk, has key implications for both equity investors in the firm and the managers of the firm. For equity investors, it is the rate that they need to make to be compensated for the risk that they have taken on investing in the firm. If after analyzing an investment, they conclude that they cannot make this return, they would not buy this investment; alternatively, if they decide they can make a higher return, they would make the investment. For managers in the firm, the return that investors need to make to break even on their equity investments becomes the return that they have to try and deliver to keep these investors from becoming restive and rebellious. Thus, it becomes the rate that they have to beat in terms of returns on their equity investments in individual project. In other words, this is the cost of equity to the firm.

Illustration 4.11: Estimating the Cost of Equity

In illustration 4.5, we estimated a bottom-up levered beta for Disney and each of its divisions. Using the prevailing treasury bond rate of 4% and the historical risk premium of 4.82% from table 4.2, we estimate the cost of equity for Disney as a company and for each of its divisions:

Table 4.11: Levered Beta and Cost of Equity: Disney

Business

Unlevered Beta

DIE Ratio

Levered Beta

Cost of Equity

Media Networks

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