Lecture 2b The cost of capital and CAPM. Overview The cost of capital Risk Risk and return Cost of equity: CAPM.

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Presentation transcript:

Lecture 2b The cost of capital and CAPM

Overview The cost of capital Risk Risk and return Cost of equity: CAPM

Cost of capital Terms on which privatised companies can raise funds for regulated businesses Two main types of capital: –Debt –Equity

Debt or bond finance “Guaranteed” interest payments (before equity holders) Tax deductible Normally lower cost than equity Cost of debt = risk free rate plus risk premium Risk free rate measured by gov’t stocks Risk premium depends on rating assessed by rating agencies

Equity finance Gives shareholders rights to residual incomes –higher risk than debt Shareholders can spread risk by holding balanced portfolio of equities But even a completely balanced equity portfolio has a risk = market risk –cannot be diversified This market risk has a risk premium = market risk premium (topic for another day)

Calculating the cost of capital Weighted average cost of capital = cost of debt  proportion of debt in financing + cost of equity  proportion of equity in financing cost of finance =risk free rate +risk premium Equity risk premium = market risk premium  equity “beta” Beta measures the relative risk of the company’s equity with that of the market as a whole Based on Capital Asset Pricing Model

Different Betas Return to market Return to Equity Low Beta =>low cost of equity Beta = 1 CoC = risk free rate + equity risk premium High Beta and equity cost

Company “Beta” Ideally should relate to regulated company rather than plc Based on degree to which company reutrns vary with those of market. Estimated from regression equation: company return = alpha + beta  market return For regulated companies Beta should be <1

Using data Returns to stock –price increase: log(p t )-log(p t-1 ) plus –dividend: added in at day goes ex-dividend Regressed on stock market return: –price change plus dividends Rough measure, data easily found: –just look at price changes - see today's lab

Further reading A study into certain aspects of the cost of capital for regulated utilities in the UK February 2003 Paper 08/03 from Ofgem Authors are academics and core paradigm is nondiversifiable risk.