Lecture 2b

1
Lecture 2b

• The cost of capital and CAPM

2
Overview

• The cost of capital
• Risk
• Risk and return
• Cost of equity CAPM

3
Cost of capital

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

4
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 govt stocks
• Risk premium depends on rating assessed by rating
  agencies

5
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)

6
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 companys
  equity with that of the market as a whole
• Based on Capital Asset Pricing Model

7
Different Betas

8
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 equationcompany
  return alpha beta ? market return
• For regulated companies Beta should be lt1

9
Using data

• Returns to stock
• price increase log(pt)-log(pt-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

10
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.