The cost of equity

Section E of the Study Guide for Paper F9 contains several

references to the Capital Asset Pricing Model (CAPM). This
article introduces the CAPM and its components, shows how it
can be used to estimate the cost of equity, and introduces the
asset beta formula. Two further articles will look at applying the
CAPM in calculating a project-specific discount rate, and will
review the theory, and the advantages and disadvantages of
the CAPM.
Whenever an investment is made, for example in the shares of
a company listed on a stock market, there is a risk that the
actual return on the investment will be different from the
expected return. Investors take the risk of an investment into
account when deciding on the return they wish to receive for
making the investment. The CAPM is a method of calculating
the return required on an investment, based on an assessment
of its risk.
SYSTEMATIC AND UNSYSTEMATIC RISK
If an investor has a portfolio of investments in the shares of a
number of different companies, it might be thought that the
risk of the portfolio would be the average of the risks of the
individual investments. In fact, it has been found that the risk of
the portfolio is less than the average of the risks of the
individual investments. By diversifying investments in a
portfolio, therefore, an investor can reduce the overall level of
risk faced.
There is a limit to this risk reduction effect, however, so that
even a fully diversified portfolio will not eliminate risk entirely.
The risk which cannot be eliminated by portfolio diversification
is called undiversifiable risk or systematic risk, since it is the
risk that is associated with the financial system. The risk which
can be eliminated by portfolio diversification is called
diversifiable risk, unsystematic risk, or specific risk, since it
is the risk that is associated with individual companies and the
shares they have issued. The sum of systematic risk and
unsystematic risk is called total risk (Watson D and Head A,
Corporate Finance: Principles and Practice, Financial Times/
Prentice Hall, 2006, p213).

THE CAPITAL ASSET PRICING MODEL

The CAPM assumes that investors hold fully diversified
portfolios. This means that investors are assumed by the CAPM
to want a return on an investment based on its systematic risk
alone, rather than on its total risk. The measure of risk used in
the CAPM, which is called beta, is therefore a measure of
systematic risk.
The minimum level of return required by investors occurs when
the actual return is the same as the expected return, so that
there is no risk at all of the return on the investment being
different from the expected return. This minimum level of
return is called the risk-free rate of return.
The formula for the CAPM, which is included in the Paper F9
formulae sheet, is as follows:
E(ri ) = Rf + i(E(rm) Rf)
E(ri) = return required on financial asset i
Rf = risk-free rate of return
i = beta value for financial asset i
E(rm) = average return on the capital market
This formula expresses the required return on a financial asset
as the sum of the risk-free rate of return and a risk premium
i (E(rm) - Rf) which compensates the investor for the
systematic risk of the financial asset. If shares are being
considered, E(rm) is the required return of equity investors,
usually referred to as the cost of equity.
The formula is that of a straight line, y = a + bx, with i as the
independent variable, Rf as the intercept with the y axis, (E(r m
) - Rf) as the slope of the line, and E(ri) as the values being
plotted on the straight line. The line itself is called the security
market line (SML), as shown in Figure 1.

In order to use the CAPM, investors need to have values for the
variables contained in the model.
THE RISK-FREE RATE OF RETURN
In the real world, there is no such thing as a risk-free asset.
Short-term government debt is a relatively safe investment,
however, and in practice, it can be used as an acceptable
substitute for the risk-free asset.
In order to have consistency of data, the yield on UK treasury
bills is used as a substitute for the risk-free rate of return when
applying the CAPM to shares that are traded on the UK capital
market. Note that it is the yield on treasury bills which is used
here, rather than the interest rate. The yield on treasury bills
(sometimes called the yield to maturity) is the cost of debt of
the treasury bills.
Because the CAPM is applied within a given financial system,
the risk-free rate of return (the yield on short-term government
debt) will change depending on which countrys capital market
is being considered. The risk-free rate of return is also not fixed,
but will change with changing economic circumstances.
THE EQUITY RISK PREMIUM
Rather than finding the average return on the capital market,

E(r m ), research has concentrated on finding an appropriate

value for (E(r m ) - R f ), which is the difference between the
average return on the capital market and the risk-free rate of
return. This difference is called the equity risk premium, since it
represents the extra return required for investing in equity
(shares on the capital market as a whole) rather than investing
in risk-free assets.
In the short term, share prices can fall as well as increase, so
the average return on a capital market can be negative as well
as positive. To smooth out short-term changes in the equity risk
premium, a time-smoothed moving average analysis can be
carried out over longer periods of time, often several decades.
In the UK, when applying the CAPM to shares that are traded on
the UK capital market, an equity risk premium of between 3.5%
and 5% appears reasonable at the current time (Ibid, p229).
BETA
Beta is an indirect measure which compares the systematic risk
associated with a companys shares with the systematic risk of
the capital market as a whole. If the beta value of a companys
shares is 1, the systematic risk associated with the shares is
the same as the systematic risk of the capital market as a
whole.
Beta can also be described as an index of responsiveness of
the returns on a companys shares compared to the returns on
the market as a whole. For example, if a share has a beta value
of 1, the return on the share will increase by 10% if the return
on the capital market as a whole increases by 10%. If a share
has a beta value of 0.5, the return on the share will increase by
5% if the return on the capital market increases by 10%, and so
on.
Beta values are found by using regression analysis to compare
the returns on a share with the returns on the capital market.
When applying the CAPM to shares that are traded on the UK
capital market, the beta value for UK companies can readily be
found on the Internet, on Datastream, and from the London
Business School Risk Management Service.
EXAMPLE 1

Calculating the cost of equity using the CAPM

Although the concepts of the CAPM can appear complex, the
application of the model is straightforward. Consider the
following information:
Risk-free rate of return = 4%
Equity risk premium = 5%
Beta value of RD Co = 1.2
Using the CAPM:
E(ri) = Rf + i (E(rm) - Rf) = 4 + (1.2 x 5) = 10%
The CAPM predicts that the cost of equity of RD Co is 10%. The
same answer would have been found if the information had
given the return on the market as 9%, rather than giving the
equity risk premium as 5%.
ASSET BETAS, EQUITY BETAS, AND DEBT BETAS
If a company has no debt, it has no financial risk and its beta
value reflects business risk alone. The beta value of a
companys business operations as a whole is called the asset
beta. As long as a companys business operations, and hence
its business risk, do not change, its asset beta remains
constant.
When a company takes on debt, its gearing increases and
financial risk is added to its business risk. The ordinary
shareholders of the company face an increasing level of risk as
gearing increases and the return they require from the
company increases to compensate for the increasing risk. This
means that the beta of the companys shares, called the equity
beta, increases as gearing increases (Ibid, p250).
However, if a company has no debt, its equity beta is the same
as its asset beta. As a company gears up, the asset beta
remains constant, even though the equity beta is increasing,
because the asset beta is the weighted average of the equity
beta and the beta of the companys debt. The asset beta
formula, which is included in the Paper F9 formulae sheet, is as
follows:

Note from the formula that if Vd is zero because a company has

no debt, then a = e, as stated earlier.
EXAMPLE 2
Calculating the asset beta of a company
You have the following information relating to RD Co: Equity
beta of RD Co = 1.2 Debt beta of RD Co = 0.1 Market value of
shares of RD Co = $6m Market value of debt of RD Co = $1.5m
After tax market value of company = 6 + (1.5 x 0.75) =
$7.125m Company profit tax rate = 25% per year a = [(1.2 x
6)/7.125] + [(0.1 x 1.5 x 0.75)/7.125] = 1.024 The next article
will look at how the asset beta formula allows the CAPM to be
applied when calculating a project-specific discount rate that
can be used in investment appraisal.

Project-specific discount rates

Section E of the Study Guide for Paper F9 contains several
references to the capital asset pricing model (CAPM). This
article, the second in a series of three, looks at how to apply
the CAPM when calculating a project-specific discount rate to
use in investment appraisal. The first article in the series
introduced the CAPM and its components, showed how the

model could be used to estimate the cost of equity, and

introduced the asset beta formula. The third and final article
will look at the theory, advantages, and disadvantages of the
CAPM.
As mentioned in the first article, the CAPM is a method of
calculating the return required on an investment, based on an
assessment of its risk. When the business risk of an investment
project differs from the business risk of the investing company,
the return required on the investment project is different from
the average return required on the investing companys
existing business operations. This means that it is not
appropriate to use the investing companys existing cost of
capital as the discount rate for the investment project. Instead,
the CAPM can be used to calculate a project-specific discount
rate that reflects the business risk of the investment project.
PROXY COMPANIES AND PROXY BETAS
The first step in using the CAPM to calculate a project-specific
discount rate is to obtain information on companies with
business operations similar to those of the proposed
investment project. For example, if a food processing company
was looking at an investment in coal mining, it would need to
obtain information on some coal mining companies; these
companies are referred to as proxy companies. Since their
equity betas represent the business risk of the proxy
companies business operations, they are referred to as proxy
equity betas or proxy betas.
From a CAPM point of view, these proxy betas can be used to
represent the business risk of the proposed investment project.
For example, the proxy betas from several coal mining
companies ought to represent the business risk of an
investment in coal mining.
BUSINESS RISK AND FINANCIAL RISK
If you were to look at the equity betas of several coal mining
companies, however, it is very unlikely that they would all have
the same value. The reason for this is that equity betas reflect

not only the business risk of a companys operations, but also

the financial risk of a company. The systematic risk represented
by equity betas, therefore, includes both business risk and
financial risk.
In the first article in this series, we introduced the idea of the
asset beta, which is linked to the equity beta by the asset beta
formula. This formula is included in the Paper F9 formulae sheet
and is as follows:

To proceed further with calculating a project-specific discount

rate, it is necessary to remove the effect of the financial risk or
gearing from each of the proxy equity betas in order to find
their asset betas, which are betas that reflect business risk
alone. If a company has no gearing, and hence no financial risk,
its equity beta and its asset beta are identical.
UNGEARING EQUITY BETAS
The asset beta formula is somewhat unwieldy and so it is
common practice to make the simplifying assumption that the
debt beta ( d ) is zero. This can be seen as a relatively minor
simplification if it is recognised that the debt beta is usually
very small in comparison to the equity beta ( e ). In addition,

the market value of a companys debt (V d ) is usually very

small in comparison to the market value of its equity (V e ), and
the tax efficiency of debt reduces the weighting of the debt
beta even further.
Making the assumption that the debt beta is zero means that
the asset beta formula becomes:

If the equity beta, the gearing, and the tax rate of the proxy
company are known, this amended asset beta formula can be
used to calculate the proxy companys asset beta. Since this
calculation removes the effect of the financial risk or gearing of
the proxy company from the proxy beta, it is usually called
ungearing the equity beta. Similarly, the amended asset beta
formula is called the ungearing formula.
AVERAGING ASSET BETAS
After the equity betas of several proxy companies have been
ungeared, it is usually found that the resulting asset betas have
slightly different values. This is not that surprising, since it is
very unlikely that two proxy companies will have exactly the
same business risk from a systematic risk point of view. Even
two coal mining companies will not be mining the same coal
seam, or mining the same kind of coal, or selling coal into the
same market. If one of the calculated asset betas is very

different from the others, however, it would be regarded with

suspicion and excluded from further consideration.
In order to remove the effect of the slight differences in
business operations and business risk that are reflected in the
asset betas, these betas are averaged. A simple arithmetic
average is calculated by adding up the asset betas and then
dividing by the number of asset betas being averaged.
REGEARING THE ASSET BETA
The average asset beta represents the business risk of the
proposed investment project. Before a project-specific discount
rate can be calculated, however, the financial risk of the
investing company needs to be taken into consideration. In
other words, having ungeared the proxy equity betas when
calculating the asset betas, it is now necessary to regear the
average proxy asset beta to reflect the gearing and the
financial risk of the investing company.
One way to approach regearing is to use the ungearing formula,
inserting the gearing and the tax rate of the investing
company, and the average asset beta, and leaving the equity
beta as the only unknown variable. Another approach is to
rearrange the ungearing formula in order to represent the
equity beta in terms of the asset beta, as follows:

The gearing and the tax rate of the investing company, and the
average proxy asset beta, are inserted into the right - hand side
of the regearing formula in order to calculate the regeared
equity beta.
CALCULATING THE PROJECT-SPECIFIC DISCOUNT RATE
The CAPM can now be used to calculate a project-specific cost
of equity. Once values have been obtained for the risk-free rate
of return, and either the equity risk premium or the return on
the market, these can be inserted into the CAPM formula along
with the regeared equity beta:

The project-specific cost of equity can be used as the projectspecific discount rate or project-specific cost of capital. It is also
possible to go further and calculate a project-specific weighted
average cost of capital, but this does not concern us in this
article and it is a step that is often omitted when using the
CAPM in investment appraisal.
SUMMARY OF STEPS IN THE CALCULATION
The steps in calculating a project-specific discount rate using
the CAPM can now be summarised, as follows (Watson D and
Head A, Corporate Finance: Principles and Practice, 4th edition,
FT Prentice Hall, pp 250255, 2007):
1. Locate suitable proxy companies.
2. Determine the equity betas of the proxy companies, their
gearings and tax rates.

3. Ungear the proxy equity betas to obtain asset betas.

4. Calculate an average asset beta.
5. Regear the asset beta.
6. Use the CAPM to calculate a project-specific cost of equity.
The difficulties and practical problems associated with using the
CAPM to calculate a project-specific discount rate to use in
investment appraisal will be discussed in the next article in this
series.
EXAMPLE 1
A company is planning to invest in a new project that is
significantly different from its existing business operations. This
company is financed 30% by debt and 70% by equity. It has
located three companies with business operations similar to the
proposed investment, and details of these companies are as
follows:
Company A has an equity beta of 0.81 and is financed 25% by
debt and 75% by equity.
Company B has an equity beta of 0.98 and is financed 40% by
debt and 60% by equity.
Company C has an equity beta of 1.16 and is financed 50% by
debt and 50% by equity.
Assume that the risk-free rate of return is 4% per year, and that
the equity risk premium is 6% per year. Assume also that all the
companies pay tax at a rate of 30% per year. Calculate a
project-specific discount rate for the proposed investment.
Solution
Ungearing the proxy equity betas: Asset beta for Company A
= 0.81 x 75//((75 + 25(1 - 0.30)) = 0.657
Asset beta for Company B = 0.98 x 60//((60 + 40(1 - 0.30)) =
0.668
Asset beta for Company C = 1.16 x 50//((50 + 50(1 - 0.30)) =
0.682

Averaging the asset betas:

(0.657 + 0.668 + 0.682)/3 = 2.007/3 = 0.669
Regearing the average asset beta: 0.669 = e x 70//((70 +
30(1 - 0.30)) = e x 0.769 Hence e = 0.669/0.769 = 0.870
If the regearing equation were used:
e = 0.669 x ((1 + (1 - 0.30)30/70) = 0.870
Calculating the project-specific discount rate:
E(ri) = Rf + i (E(rm) - Rf) = 4 + (0.870 x 6) = 4 + 5.22 = 9.2%