Question

Referencing textbook readings, lecture material, and current business resources explainmethods for estimating cost of debt, methods of estimating cost of equity. Also, discuss the difference between asset and equity betas used in CAPM to estimate cost of equity.

If WACC is so sensitive to accurate estimation of its components (weights and individual costs), why is it still so widely used in the industry? How would you improve quality of capital budgeting process that relies on using WACC?

Answer 1

COST OF EQUITY: CAPITAL ASSET PRICING MODEL

RISK-FREE RATE

To estimate risk-free rate practitioners typically use government securities that best match forecast period of the cash flows. Government bonds are assumed to be risk-free under assumption that government will always be able to meet the payments – at least in nominal terms - by printing more currency. As a result, returns on such security has no covariance with the market as represented by zero beta in the CAPM.

BETA ESTIMATION

It is the systematic risk. It is sensitivity of the asset movement to the market. It is calculated using regression analysis.

Cost of debt

The cost of debt is the yield to maturity of debt. The tax shield on the interest is also deducted.

Equity Beta accounts for the company's capital structure - meaning that if the company has loaded up on debt it will be more volatile than companies that have less debt within the capital structure.

Asset Beta measures how volatile the underlying business is without considering capital structure. You calculate asset beta by removing the capital structure impact on the equity beta. Asset beta is also frequently referred to as unlevered beta.

The WACC includes the total cost as it considers all type of financing so it is really useful to calculate net pesesent value. The cash flow are related to total investment so total discounting cost is required.