Chapter 12

Estimating the Cost of Capital

12-1. Suppose Pepsico’s stock has a beta of 0.72. If the risk-free rate is 2% and the expected return of
the market portfolio is 6%, what is Pepsico’s equity cost of capital?

r i=r f + β i × ( E [ R Mkt ] −r f )
r Pepsico =2 %+0.72 × ( 6 %−2% )=4.88 %

12-2. Suppose the market portfolio has an expected return of 10% and a volatility of 20%, while
Microsoft’s stock has a volatility of 30%.
a. Given its higher volatility, should we expect Microsoft to have an equity cost of capital that is
higher than 10%?
b. What would have to be true for Microsoft’s equity cost of capital to be equal to 10%?
a. No, volatility includes diversifiable risk, so it cannot be used to assess the equity cost of capital.
b. Microsoft stock would need to have a beta of 1.

12-3. Aluminum maker Alcoa has a beta of about 1.73, whereas Hormel Foods has a beta of 1.68. If the
expected excess return of the marker portfolio is 3%, which of these firms has a higher equity
cost of capital, and how much higher is it?

r i= βi × ( E [ R Mkt ]−r f )
r Alcoa =1.73 × ( 3 % )=5.19 %
r Hormel =1.68 × ( 3 % )=5.04 %

Alcoa’s cost of capital is higher by 0.15%.

12-4. Suppose all possible investment opportunities in the world are limited to the five stocks listed in
the table below. What does the market portfolio consist of (what are the portfolio weights)?

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Total value of the market billion

Stock Portfolio Weight

12-5. Using the data in Problem 4, suppose you are holding a market portfolio, and have invested
$12,000 in Stock C.
a. How much have you invested in Stock A?
b. How many shares of Stock B do you hold?
c. If the price of Stock C suddenly drops to $4 per share, what trades would you need to make
to maintain a market portfolio?
Best Buy has $9 / $24 = 0.375 billion shares outstanding
Therefore, you hold 132 x (2.43/0.375) = 855 shares of Disney.

12-6. Suppose Best Buy stock is trading for $30 per share for a total market cap of $9 billion, and Walt
Disney has 1.65 billion shares outstanding. If you hold the market portfolio, and as part of it hold
100 shares of Best Buy, how many shares of Walt Disney do you hold?
Best Buy has 9/30 = 0.3 billion shares outstanding.
Therefore, you hold 100  (1.65/0.3) = 550 shares of Disney.

12-7. Standard and Poor’s also publishes the S&P Equal Weight Index, which is an equally weighted
version of the S&P 500.
a. To maintain a portfolio that tracks this index, what trades would need to be made in
response to daily price changes?
b. Is this index suitable as a market proxy?
a. Sell winners and buy losers to maintain an equal investment in each.
b. No. The market portfolio should represent the aggregate portfolio of all investors. However, in
aggregate, investors must hold more of the larger market cap stocks; the aggregate portfolio is
value weighted, not equally weighted.

12-8. Suppose that in place of the S&P 500, you wanted to use a broader market portfolio of all U.S.
stocks and bonds as the market proxy. Could you use the same estimate for the market risk
premium when applying the CAPM? If not, how would you estimate the correct risk premium to
use?
No, expected return of this portfolio would be lower due to bonds. Compute the historical excess return
of this new index.

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 Chapter 12/Estimating the Cost of Capital 194

12-9. From the start of 1999 to the start of 2009, the S&P 500 had a negative return. Does this mean
the market risk premium we should have used in the CAPM was negative?
No! Investors were not expecting a negative return. To estimate an expected return, we need much
more data.

12-10. You need to estimate the equity cost of capital for XYZ Corp. You have the following data
available regarding past returns:
Year Risk-free Return Market Return XYZ Return
2017 4% 7% 8%
2018 1% -43% -37%

a. What was XYZ’s average historical return?

b. Compute the market’s and XYZ’s excess returns for each year. Estimate XYZ’s beta.
c. Estimate XYZ’s historical alpha.
d. Suppose the current risk-free rate is 4%, and you expect the market’s return to be 8%. Use
the CAPM to estimate an expected return for XYZ Corp.’s stock.
e. Would you base your estimate of XYZ’s equity cost of capital on your answer in part (a) or
in part (d)? How does your answer to part (c) affect your estimate? Explain.
( 8 %−37 % )
a. XYZ average historical returns= =−14.5 %
2
b. Market excess return 2017 = 7% - 4% = 3%
Market excess return 2018 = -43% - 1% = -44%

XYZ excess return 2017 = 8% - 4% = 4%

XYZ excess return 2018 = -37% - 1% = -38%

( 4−(−38 ) )
Beta= =0.89
( 3−(−44 ) )

c. Alpha=intercept =E [ R s−r f ]−beta × ( E [ R s−r f ] )

( 4 %−38 % ) ( 3 %−44 % )
Alpha=intercept = −0.89 × =−17 %+ 18.245 %=1.25 %
2 2
a. E ( r XYZ ) =4 %+0.89 × ( 8 %−4 % ) =7.56 %

e. Use (d)— because the CAPM provides a better estimate of expected returns.

12-11. Go to Chapter Resources on MyFinanceLab and use the data in the spreadsheet provided to
estimate the beta of Nike and HPQ stock based on their monthly returns from 2011–2015. (Hint:
You can use the slope() function in Excel.)
NKE 0.603
HPQ 1.73

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195 Berk/DeMarzo, Corporate Finance, Fourth Edition

12-12. Using the same data as in Problem 11, estimate the alpha of Nike and HPQ stock, expressed as %
per month. (Hint: You can use the intercept() function in Excel.)
NKE = 1.04%/month
HPQ = –1.02% per month

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 Chapter 12/Estimating the Cost of Capital 196

12-13. Using the same data as in Problem 11, estimate the 95% confidence interval for the alpha and
beta of Nike and HPQ stock using Excel’s regression tool (from the data analysis menu) or the
linest() function.

12-14. In mid-2017, Ralston Purina had AA-rated, 10-year bonds outstanding with a yield to maturity
of 2.36%.
a. What is the highest expected return these bonds could have?
b. At the time, similar maturity Treasuries have a yield of 1.36%. Could these bonds actually
have an expected return equal to your answer in part (a)?
c. If you believe Ralston Purina’s bonds have 0.5% chance of default per year, and that
expected loss rate in the event of default is 48%, what is your estimate of the expected return
for these bonds?
a. Highest expected returns for the bonds would be 2.36%

b. No, if the bonds are risk-free, the expected return equals the risk-free rate, and if they are not
risk-free the expected return is less than the yield.

c. 2.36 %−( 0.005 × 48 % )=2.12 %

12-15. In mid-2012, Rite Aid had CCC-rated, 6-year bonds outstanding with a yield to maturity of
17.3%. At the time, similar maturity Treasuries had a yield of 3%. Suppose the market risk
premium is 6% and you believe Rite Aid’s bonds have a beta of 0.31. The expected loss rate of
these bonds in the event of default is 58%.

a. What annual probability of default would be consistent with the yield to maturity of these
bonds in mid-2009?

b. In mid-2015, Rite-Aid’s bonds had a yield of 6.6%, while similar maturity Treasuries had a
yield of 1.6%. What probability of default would you estimate now?
a. Rd = 3% + 0.31(6%) = 4.86% = y – pL = 17.3% – p(0.58)
p = (17.3% – 4.86%)/0.58 = 21.45%

b. p = (6.6% – 1.6% – 0.31(6%))/0.58 = 5.41%

12-16. During the recession in mid-2009, homebuilder KB Home had outstanding 6-year bonds with a
yield to maturity of 8.5% and a BB rating. If corresponding risk-free rates were 3%, and the
market risk premium was 5%, estimate the expected return of KB Home’s debt using two
different methods. How do your results compare?
Given the low rating of debt, as well as the recessionary economic conditions at the time, we know the
yield to maturity of KB Home’s debt is likely to significantly overstate its expected return. Using the
recession estimates in Table 12.2 and an expected loss rate of 60%, from Eq. 12.7 we have

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Alternatively, we can estimate the bond’s expected return using the CAPM and an estimated beta of
0.17 from Table 12.3. In that case,

While both estimates are rough approximations, they both confirm that the expected return of KB
Home’s debt is well below its promised yield.

12-17. The Dunley Corp. plans to issue 5-year bonds. It believes the bonds will have a BBB rating.
Suppose AAA bonds with the same maturity have a 4% yield. Assume the market risk premium
is 5% and use the data in Table 12.2 and Table 12.3.
a. Estimate the yield Dunley will have to pay, assuming an expected 60% loss rate in the event
of default during average economic times. What spread over AAA bonds will it have to pay?
b. Estimate the yield Dunley would have to pay if it were a recession, assuming the expected
loss rate is 80% at that time, but the beta of debt and market risk premium are the same as
in average economic times. What is Dunley’s spread over AAA now?
c. In fact, one might expect risk premia and betas to increase in recessions. Redo part (b)
assuming that the market risk premium and the beta of debt both increase by 20%; that is,
they equal 1.2 times their value in recessions.
a. Use CAPM to estimate expected return, using AAA rate as rf rate: r + 0.1  rp = 4% + 0.10(5%) =
4.5%
So, y – p  l = 4.5%
y = 4.5% + p(60%) = 4.5% + 0.4%(60%) = 4.74%
Spread = 0.74%
b. Use CAPM to estimate expected return, using AAA rate as rf rate: r + 0.1  rp = 4% + 0.10(5%) =
4.5%
y = 4.5% + 3%(80%) = 6.90%
Spread = 2.9%
c. Use CAPM to estimate expected return, using AAA rate as rf rate: r +0.1  1.2  rp  1.2 = 4% +
0.10(5%)1.22 = 4.72%
So, y – p  l = 4.5%
y = 4.72% + p(80%) = 4.72% + 3%(80%) = 7.12%
Spread = 3.12%

12-18. Your firm is planning to invest in an automated packaging plant. Harburtin Industries is an all-
equity firm that specializes in this business. Suppose Harburtin’s equity beta is 0.85, the risk-free
rate is 4%, and the market risk premium is 5%. If your firm’s project is all equity financed,
estimate its cost of capital.
Project beta = 0.85 (using all equity comp)
Thus, rp = 4% + 0.85(5%) = 8.25%

12-19. Consider the setting of Problem 18. You decided to look for other comparables to reduce
estimation error in your cost of capital estimate. You find a second firm, Thurbinar Design,
which is also engaged in a similar line of business. Thurbinar has a stock price of $20 per share,

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with 15 million shares outstanding. It also has $100 million in outstanding debt, with a yield on
the debt of 4.5%. Thurbinar’s equity beta is 1.00.
a. Assume Thurbinar’s debt has a beta of zero. Estimate Thurbinar’s unlevered beta. Use the
unlevered beta and the CAPM to estimate Thurbinar’s unlevered cost of capital.
b. Estimate Thurbinar’s equity cost of capital using the CAPM. Then assume its debt cost of
capital equals its yield, and using these results, estimate Thurbinar’s unlevered cost of
capital.
c. Explain the difference between your estimate in part (a) and part (b).
d. You decide to average your results in part (a) and part (b), and then average this result with
your estimate from Problem 17. What is your estimate for the cost of capital of your firm’s
project?
a. E = 20  15 = 300
E + D = 400
Bu = 300/400  1.00 + 100/400  0 = 0.75
Ru = 4% + 0.75(5%) = 7.75%
b. Re = 4% + 1.0  5% = 9%
Ru = 300/400  9% + 100/400  4.5% = 7.875%
c. In the first case, we assumed the debt had a beta of zero, so rd = rf = 4%
In the second case, we assumed rd = ytm = 4.5%
d. Thurbinar Ru = (7.75 + 7.875)/2 = 7.8125%
Harburtin Ru = 8.25%
Estimate = (8.25% + 7.8125%)/2 = 8.03%

12-20. IDX Tech is looking to expand its investment in advanced security systems. The project will be
financed with equity. You are trying to assess the value of the investment, and must estimate its
cost of capital. You find the following data for a publicly traded firm in the same line of business:

$423 million
Debt Outstanding (book value, AA-rated)
Number of shares of common stock 67 million
Stock price per share $17.29
Book value of equity per share $6.24
1.19
Beta of equity

What is your estimate of the project’s beta? What assumptions do you need to make?

E=67 × $ 17.29=$ 1,158.43

D=$ 423
β E =1.37 ; β D =0
E+ D=$ 1,158.43+$ 423=$ 1,581.43
1,158.43 423
B u= × 1.19+ ×0=0.87
1,581.43 1,581.43

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12-21. In mid-2015, Cisco Systems had a market capitalization of $123 billion. It had A-rated debt of
$21 billion as well as cash and short-term investments of $62 billion, and its estimated equity
beta at the time was 1.32.
a. What is Cisco’s enterprise value?
b. Assuming Cisco’s debt has a beta of zero, estimate the beta of Cisco’s underlying business
enterprise.
a. EV = E + D – C = $123 + $21 – $62 = $82 billion
123 −41
b. B u= × 1.32+ ×0=1 .98
82 82

12-22. Consider the following airline industry data from mid-2009:

Market
Company Name Capitalization Total Enterprise Equity Beta Debt Ratings
($mm) Value ($mm)
Delta Air Lines (DAL) 4,938.5 17,026.5 2.04 BB

Southwest Airlines (LUV) 4,896.8 6,372.8 0.966 A/BBB

JetBlue Airways (JBLU) 1,245.5 3,833.5 1.91 B/CCC

Continental Airlines (CAL) 1,124.0 4,414.0 1.99 B

a. Use the estimates in Table 12.3 to estimate the debt beta for each firm (use an average if
multiple ratings are listed).
b. Estimate the asset beta for each firm.
c. What is the average asset beta for the industry, based on these firms?

Risk-free Rate Market Return XYZ Return Excess

2007 3% 6% 10% 3% 7%
2008 1% -37% -45% -38% -46%

12-23. Weston Enterprises is an all-equity firm with two divisions. The soft drink division has an asset
beta of 0.68, expects to generate free cash flow of $55 million this year, and anticipates a 3%
perpetual growth rate. The industrial chemicals division has an asset beta of 1.04, expects to
generate free cash flow of $70 million this year, and anticipates a 2% perpetual growth rate.
Suppose the risk-free rate is 2% and the market risk premium is 4%.
a. Estimate the value of each division.
b. Estimate Weston’s current equity beta and cost of capital. Is this cost of capital useful for
valuing Weston’s projects? How is Weston’s equity beta likely to change over time?
a. R SD=2 %+ 0.68 ( 4 % )=4.72 %
$ 55
V SD = =$ 3,197.7 million
( 0.0472−0.03 )

RC =2% +1.04 ( 4 % )=6.16 %

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 Chapter 12/Estimating the Cost of Capital 200

$ 70
V SD = =$ 1,682.7 million
( 0.0616−0.02 )
Total value of firm = $3,197.7 + $1,682.7 = $4,880.4 million

3,197.7 1,682.7
b. B u= × 0.68+ ×1.04=0.80
4,880.4 4,880.4

r u =2% +0.8 × ( 4 % )=5.2 %

It is not useful! Individual divisions are sometimes less risky and sometimes more risky than
the firm's cost of capital.

Over time, Weston's equity beta will decline toward 0.68, as the soft drink division has a
higher growth rate and so will represent a larger fraction of the firm.

12-24. Harrison Holdings, Inc. (HHI) is publicly traded, with a current share price of $30 per share.
HHI has 23 million shares outstanding, as well as $70 million in debt. The founder of HHI, Harry
Harrison, made his fortune in the fast food business. He sold off part of his fast food empire, and
purchased a professional hockey team. HHI’s only assets are the hockey team, together with 50% of the
outstanding shares of Harry’s Hotdogs restaurant chain. Harry’s Hotdogs (HDG) has a market
capitalization of $803 million, and an enterprise value of $1.05 billion. After a little research, you find
that the average asset beta of other fast food restaurant chains is 0.72. You also find that the debt of HHI
and HDG is highly rated, and so you decide to estimate the beta of both firms’ debt as zero. Finally, you
do a regression analysis on HHI’s historical stock returns in comparison to the S&P 500, and estimate an
equity beta of 1.32. Given this information, estimate the beta of HHI’s investment in the hockey team.
HHI Equity = 30 x 23 = $690
HHI debt = $70
HHI asset beta = (690/(690 + 70))1.32 + (70/(690 + 70))0 = 1.20
Holdings of Hotdogs = $803/2 = 401.5
Value of Hockey Team = (690 + 70) – 401.5 = $358.5
Hotdog equity beta: (803/1,050) x Be + ((1050 − 803)/1,050) x 0 = 0.72
0.7647Be = 0.72
Be = 0.74 / 0.7647 = 0.941 for hotdog equity
So, if B = hockey team beta,
(401.5/(401.5 + 358.5))0.941 + (358.5/(401.5 + 358.5)) x B = 1.2
0.4971 + 0.4717B = 1.2
0.4717B = 1.2 – 0.4971 = 0.7029
Beta of hockey team = 0.7029 / 0.4717 = 1.49

12-25. Your company operates a steel plant. On average, revenues from the plant are $50 million per
year. All of the plants costs are variable costs and are consistently 70% of revenues, including energy
costs associated with powering the plant, which represent one quarter of the plant’s costs, or an average
of $8.75 million per year. Suppose the plant has an asset beta of 1.19, the risk-free rate is 2%, and the
market risk premium is 5%. The tax rate is 36%, and there are no other costs.

a. Estimate the value of the plant today assuming no growth.

b. Suppose you enter a long-term contract which will supply all of the plant’s energy needs for
a fixed cost of $3 million per year (before tax). What is the value of the plant if you take this
contract?
c. How would taking the contract in (b) change the plant’s cost of capital? Explain.

a. FCF = ($50 – 0.7($50))(1 – 0.36) = $9.6 million

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Ru = 2% + 1.19 x 5% = 7.95%

V = $9.6 / 0.0795 = $120.75 million

b. FCF without energy = ($50 – $26.25)(1 – 0.36) = $15.2

Cost of capital = 7.95%
Energy cost after tax = $3(1 – 0.36) = $1.92 million
Cost of capital = 2%
V = $15.2 / 0.0795 – $1.92 /0.02 = $191.19 million – $96 million = $95.19 million

c. FCF = $15.2 – $1.92 = $13.28 million

$13.28 / $95.10 = 0.1395 = 13.95%

Risk is increased because now energy costs are fixed. Thus, a higher cost of capital is
appropriate.

12-26. Unida Systems has 32 million shares outstanding trading for $9 per share. In addition, Unida has
$85 million in outstanding debt. Suppose Unida’s equity cost of capital is 13%, its debt cost of
capital is 9%, and the corporate tax rate is 32%.
a. What is Unida’s unlevered cost of capital?
b. What is Unida’s after-tax debt cost of capital?
c. What is Unida’s weighted average cost of capital?

a. E = 32 x $9 = $288 million
D = $85 million
Ru = 288 /(288 + 85) x 13% + 85/(288 + 85) x 9% = 12.1%

b. Rd = 9% x (1 – 32%) = 6.1%

c. Rwacc = 288/(288 + 85) x 13% + 85/(288 + 85) x 6.1% = 11.4%

12-27. You would like to estimate the weighted average cost of capital for a new airline business. Based
on its industry asset beta, you have already estimated an unlevered cost of capital for the firm of
9%. However, the new business will be 24% debt financed, and you anticipate its debt cost of
capital will be 6%. If its corporate tax rate is 32%, what is your estimate of its WACC?

Ru = 9% = 76% Re + 24%Rd = 76% Re + 24%(6%)

Re = (9% – 24%(6%))/76% = 9.95%
Rwacc = 76%(9.95%) + 24%(6%)(1 – 32%) = 6.19%
Rwacc = 7.562% + 0.9792% = 8.5%

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