Cost of equity
Since your cost of equity is based on market expectations, you estimate
the return a shareholder expects to hold on to your stock. A
common calculation
method is the capital assets pricing model (CAPM).
cost of equity capital = risk free rate of return
+ (stock beta x market risk premium)
Risk Free Rate of Return
The risk free rate of return is usually a long term US Treasury Bond,
e.g., the 10 or 20 year bond. It's a "mature" assessment of
risk. The day you buy it, you know exactly what you'll make and when
you will
get
your
principal
back.
(On
4/23/2003,
a 20 Year Treasury Bond rate of return was 4.89%. See the Federal Reserve
Board's H15
update for current rates.)
Market Risk Premium
The market risk premium is the return stock investors want beyond
the risk free rate of return. A ball park number is 7%, the average
premium expected for stocks from 1926-1999. We can calculate it using
an industry rate available
from Ibbotson Associates or a
market index's historical rate of return.
In April 2003, the Russell
3000, a broad market
index, for the last ten years had a 8.16% return and the S&P
500, a large cap index,
had a 9.66% return for the last ten year. On 4/23/2003,
the market risk premium using the Russell 3000 less the 20 year US
Treasury
bond
rate
is
3.27% = 8.16% (index return) - 4.89% (risk free
return)
"The boss" thought: this calculation requires
us to make choices about where to get the risk premium, changes with
the market, appears more art and experience than science, and 3.27%
is about half of 7% - the historical ball park.
 WACC
- Cost of debt
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WACC - Beta  |
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