Slide 1Chapter OutlineLearning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives12.1 The Equity Cost of CapitalTextbook Example 12.1Textbook Example 12.1 (cont'd)Alternative Example 12.1Alternative Example 12.1 (cont'd)Alternative Example 12.1 (cont'd)Alternative Example 12.1 (cont'd)12.2 The Market PortfolioValue-Weighted PortfoliosMarket IndexesInvesting in a Market Index12.2 The Market PortfolioThe Market Risk PremiumSlide 20The Market Risk Premium (cont’d)12.3 Beta EstimationSlide 23Slide 2412.3 Beta Estimation (cont'd)12.3 Beta Estimation (cont'd)Using Linear RegressionUsing Linear Regression (cont'd)Using Linear Regression (cont'd)Textbook Example 12.2Textbook Example 12.2 (cont’d)12.4 The Debt Cost of Capital12.4 The Debt Cost of Capital (cont’d)12.4 The Debt Cost of Capital (cont’d)Table 12.2 Annual Default Rates by Debt Rating (1983–2011)12.4 The Debt Cost of Capital (cont’d)12.4 The Debt Cost of Capital (cont’d)Table 12.3 Average Debt Betas by Rating and MaturityTextbook Example 12.3Textbook Example 12.3 (cont’d)Alternative Example 12.3Alternative Example 12.3 (cont’d)Alternative Example 12.3 (cont’d)12.5 A Project’s Cost of CapitalSlide 45Textbook Example 12.4Textbook Example 12.4 (cont’d)12.5 A Project’s Cost of Capital (cont’d)12.5 A Project’s Cost of Capital (cont’d)Textbook Example 12.5Textbook Example 12.5 (cont’d)Cash and Net DebtTextbook Example 12.6Textbook Example 12.6 (cont’d)Industry Asset BetasTextbook Example 12.7Textbook Example 12.7 (cont’d)Figure 12.4 Industry Asset Betas (2012)12.6 Project Risk Characteristics and Financing12.6 Project Risk Characteristics and Financing (cont’d)12.6 Project Risk Characteristics and Financing (cont’d)Textbook Example 12.8Textbook Example 12.8 (cont’d)Financing and the Weighted Average Cost of CapitalThe Weighted Average Cost of CapitalThe Weighted Average Cost of Capital (cont’d)Textbook Example 12.9Textbook Example 12.9 (continued)12.7 Final Thoughts on the CAPM12.7 Final Thoughts on the CAPM (continued)Discussion of Data Case Key TopicChapter QuizChapter QuizChapter QuizSlide 75Practical Considerations When Forecasting BetaPractical Considerations When Forecasting Beta (cont’d)Figure 12A.1 Estimated Betas for Cisco Systems, 1999–2012Practical Considerations When Forecasting Beta (cont’d)Practical Considerations When Forecasting Beta (continued)Slide 81Practical Considerations When Forecasting Beta (continued)Discussion of Data Case Key TopicChapter 12Estimating the Cost of CapitalCopyright ©2014 Pearson Education, Inc. All rights reserved.Chapter Outline12.1 The Equity Cost of Capital12.2 The Market Portfolio12.3 Beta Estimation12.4 The Debt Cost of Capital12.5 A Project’s Cost of Capital12.6 Project Risk Characteristics and Financing12.7 Final Thoughts on the CAPMCopyright ©2014 Pearson Education, Inc. All rights reserved.Learning Objectives1. Estimate a company’s cost of capital using the CAPM equation for the Security Market Line.2. Describe the market portfolio and how it is constructed in practice.3. Discuss the attributes of a value-weighted portfolio.4. Describe common proxies for the market return and the risk-free rate.Copyright ©2014 Pearson Education, Inc. All rights reserved.Learning Objectives5. Define alpha and beta and explain how they are generally estimated.6. Compare the use of average return versus beta and the SML to estimate cost of equity capital.7. Estimate the cost of debt, given a company’s yield to maturity, probability of default, and expected loss rate.Copyright ©2014 Pearson Education, Inc. All rights reserved.Learning Objectives8. Discuss the difference between the yield to maturity and the cost of debt when there is low versus high default risk.9. Calculate the cost of debt given a company’s debt beta, the risk free rate, and the market risk premium.10. Illustrate the use of comparable companies’ unlevered betas or unlevered cost of capital to estimate project cost of capital.Copyright ©2014 Pearson Education, Inc. All rights reserved.Learning Objectives11. Discuss the advantages of using several companies’ betas to estimate a project beta.12. Define operating leverage and discuss its influence on project risk.13. Calculate the weighted average cost of capital.14. Discuss strengths and weaknesses of the CAPM.Copyright ©2014 Pearson Education, Inc. All rights reserved.12.1 The Equity Cost of Capital•The Capital Asset Pricing Model (CAPM) is a practical way to estimate.•The cost of capital of any investment opportunity equals the expected return of available investments with the same beta.•The estimate is provided by the Security Market Line equation:Risk Premium for Security iCopyright ©2014 Pearson Education, Inc. All rights reserved.Textbook Example 12.1Copyright ©2014 Pearson Education, Inc. All rights reserved.Textbook Example 12.1 (cont'd)Copyright ©2014 Pearson Education, Inc. All rights reserved.Alternative Example 12.1•Problem–Suppose you estimate that Wal-Mart’s stock has a volatility of 16.1% and a beta of 0.20. A similar process for Johnson & Johnson yields a volatility of 13.7% and a beta of 0.54. Which stock carries more total risk? Which has more market risk? If the risk-free interest rate is 4% and you estimate the market’s expected return to be 12%, calculate the equity cost of capital for Wal-Mart and Johnson & Johnson. Which company has a higher cost of equity capital?Copyright ©2014 Pearson Education, Inc. All rights reserved.Alternative Example 12.1 (cont'd)•Solution–Total risk is measured by volatility; therefore, Wal-Mart stock has more total risk than Johnson & Johnson. Systematic risk is measured by beta. Johnson & Johnson has a higher beta, so it has more market risk than Wal-Mart. Given Johnson & Johnson’s estimated beta of 0.54, we expect the price for Johnson & Johnson’s stock to move by 0.54% for every 1% move of the market.Copyright ©2014 Pearson Education, Inc. All rights reserved.Alternative Example 12.1 (cont'd)•Solution (cont’d)–Therefore, Johnson & Johnson’s risk premium will be 0.54 times the risk premium of the market, and Johnson & Johnson’s equity cost of capital (from Eq. 12.1) isrJNJ = 4% + 0.54 × (12% − 4%) = 4% + 4.32% = 8.32%Copyright ©2014 Pearson Education, Inc. All rights reserved.Alternative Example 12.1 (cont'd)•Solution (cont’d)–Wal-Mart has a lower beta of 0.20. The equity cost of capital