Cost of Capital: Applications and Examples -- Contents -- About the Authors -- Foreword -- Preface -- Acknowledgments -- Part One: Cost of Capital Basics -- Chapter 1: Defining Cost of Capital -- Introduction -- Components of a Capital Structure -- Cost of Capital Is a Function of the Investment -- Cost of Capital Is Forward-looking -- Cost of Capital Is Based on Market Value -- Cost of Capital Is Usually Stated in Nominal Terms -- Cost of Capital Equals the Discount Rate -- Discount Rate Is Not the Same as Capitalization Rate -- Standard (Basis) of Value -- Summary -- Chapter 2: Introduction to Cost of Capital Applications: Valuation, Project Selection, and Ratemaking -- Introduction -- Net Cash Flow Is the Preferred Economic Income Measure -- Cost of Capital Is the Proper Discount Rate -- Present Value Formula -- Example: Valuing a Bond -- Applications to Businesses, Business Interests, and Capital Budgeting Projects -- Applications in Ratemaking -- Summary -- Chapter 3: Net Cash Flow: The Preferred Measure of Economic Income -- Introduction -- Defining Net Cash Flow -- Net Cash Flow to Common Equity Capital -- Net Cash Flow to Invested Capital -- Net Cash Flows Should Be Probability-weighted Expected Values -- Why Net Cash Flow Is the Preferred Measure of Economic Income -- Summary -- Additional Reading -- Appendix 3A: Alternative Measures of Economic Income -- Introduction -- Capital Cash Flow -- Adjusted Present Value -- Residua l Income -- Chapter 4: Discounting versus Capitalizing -- Introduction -- Capitalization Formula -- Example: Valuing a Preferred Stock -- Functional Relationship between Discount Rate and Capitalization Rate -- Major Difference between Discounting and Capitalizing -- Constant Growth or Gordon Growth Model -- Criticisms of the Gordon Growth Model -- Combining Discounting and Capitalizing -- Two-stage Model.

Three-stage Model -- Three-stage Model with Gradual Change in Growth -- Equivalency of Discounting and Capitalizing Models -- Summary -- Appendix 4A: Equivalency of Capitalizing Residual Income -- Chapter 5: Discounting-Beyond the Basics -- Introduction -- Midyear Convention -- Midyear Discounting Convention -- Midyear Capitalization Convention -- Midyear Convention in the Two-stage Model -- Seasonal Businesses -- Matching Projection Periods to Financial Statement Dates: Partial First Year -- Changing Risk over Time -- Midyear Convention in Two-stage Model with Changing Risk -- Duration of an Investment -- Summary -- Chapter 6: Relationship between Risk and the Cost of Capital -- Introduction -- Defining Risk -- How Risk Affects the Cost of Capital -- Valuation of Risky Net Cash Flows -- Risk Aversion versus Risk Neutrality -- Market Returns Increase as Risk Increases by Asset Class -- Types of Risk -- Maturity Risk -- Market Risk -- Company-specific Risk -- Liquidity and Marketability Risk -- Measuring Riskiness of Net Cash Flows -- ASC 820 Fair Value Measurement: Cash Flows and Present Value Discount Rates -- Summary -- Part Two: Estimating the Cost of Equity Capital -- Chapter 7: Risk-free Rate -- Introduction -- Risk-free Rate Represented by U.S. Government Securities -- Why Consider Multiple Maturities? -- Selecting the Best Risk-free Maturity -- Components of the Risk-free Rate -- Real Interest Rates -- Expected Inflation -- Build-up of Nominal Risk-free Rate -- Selecting the Best Risk-free Yield -- Summary -- Chapter 8: Equity Risk Premium -- Introduction -- Defining the Equity Risk Premium -- Nominal or Real? -- Estimating the ERP -- ERP Is Measured Relative to a Risk-free Rate -- Measuring the Average Period of the Expected Cash Flows -- Unconditional ERP -- Selecting a Sample Period of ex post Data -- Bias in Realized Risk Premium Data.

Predicting Future ERP -- Has the Relationship between Stock and Bond Risk Changed? -- Comparing Investor Expectations to Realized Risk Premiums -- Causes of Unexpectedly Large Realized Risk Premiums -- Unconditional ERP Estimates -- Conditional ERP -- Forward-looking (ex ante) Approaches -- Predicting Future ERP -- Conditional ERP Estimates -- Concluding on an ERP -- Summary -- Additional Reading -- Appendix 8A: Deriving ERP Estimates -- Realized Risk Premium (ex post) Approach -- Measuring Realized Risk Premiums -- Realized Historical Stock and Bond Returns -- Summarizing Realized Risk Premium Data -- What Periodicity of Past Measurement? -- Comparing Investor Expectations to Realized Risk Premiums -- Arnott and Bernstein -- Dimson, Marsh, and Staunton -- Grinold, Kroner, and Siegel -- Ibbotson and Chen -- Using the Geometric Average for Compounding and the Arithmetic Average for Discounting -- Compounding -- Discounting -- Is Bias Introduced by Using the Arithmetic Average as an ERP Estimate? -- Implied ex ante ERP Estimates -- Bottom-up Implied Estimates -- Top-down Implied ERP Estimates -- Top-down Risk Premium Estimates -- Surveys -- Using the Arithmetic Average Equivalent ERP for Discounting -- Appendix 8B: Other Sources of ERP Estimates -- Chapter 9: Build-up Method -- Introduction -- Formula for Estimating the Cost of Equity Capital by the Build-up Method -- Risk-free Rate -- Equity Risk Premium -- Size Premium -- Company-specific Risk Premium -- Size Smaller Than the Smallest Size Premium Group -- Incorporating an Industry Risk Factor into the Build-up Method -- Volatility of Returns -- Leverage -- Other Company-specific Factors -- Example of the Build-up Method Using Morningstar Data -- Example of the Build-up Method Using Duff & Phelps Size Study Data -- Summary -- Chapter 10: Capital Asset Pricing Model -- Introduction.

Concept of Market or Systematic Risk -- Background of the Capital Asset Pricing Model -- Market (or Systematic) and Unique (or Unsystematic) Risks -- Using Beta to Estimate Expected Rate of Return -- Modifying CAPM -- Firm Size Phenomenon -- Company-specific Risk Factor -- Modified CAPM Cost of Capital Formula -- Examples of a CAPM Model -- Example of CAPM Method Using Morningstar Data -- Example of a CAPM Method Using Duff & Phelps Size Study Data -- Assumptions Underlying the Capital Asset Pricing Model -- Summary -- Chapter 11: Beta: Differing Definitions and Estimates -- Introduction -- Estimation of Equity Beta -- Differences in Estimation of Equity Betas -- Length of the Sample or Look-back Period -- Frequency of Return Measurement -- Choice of Market Index -- Choice of Risk-free Rate -- Choosing the Best Method -- Modified Betas: Adjusted, Smoothed, and Lagged -- Adjusted Beta Incorporates Industry Norm -- Smoothed Beta -- "Sum Beta" Incorporates Lag Effect -- "Full-Information" Equity Beta -- Peer Group Equity Beta -- Fundamental Equity Beta -- Equity Beta Estimation Research -- Estimation of Debt Betas -- Other Beta Considerations -- Summary -- Appendix 11A: Examples of Computing OLS Beta, Sum Beta, and Full-information Beta Estimates -- Introduction -- Computing OLS and Sum Beta Estimates Example -- Computing Realized Return Data -- Computing OLS Beta Estimate -- Computing Sum Beta Estimate -- Computing Full-information Beta Estimate Example -- Appendix 11B: Estimating Beta: Interpreting Regression Statistics -- Introduction -- Evaluating Beta Estimation Output -- Evaluating Regression Output -- Regression Statistics Table -- ANOVA Table -- Regression Coefficient Table -- Beta Estimation-TIBCO Software, Inc. (TIBX) Example -- Chapter 12: Unlevering and Levering Equity Betas -- Introduction.

Formulas for Unlevering and Levering Equity Betas -- Hamada Formulas -- Miles-Ezzell Formulas -- Harris-Pringle Formulas -- Practitioners' Method Formulas -- Capital Structure Weights -- Fernandez Formulas -- Adjusting Formulas for Other Components of Capital Structure -- Choosing among Unlevering and Levering Formulas -- Adjusting Asset Beta Estimates for Differences in Operating Leverage -- Adjusting Asset Beta Estimates for Excess Cash and Investments -- Unlevering Equity Volatility -- Summary -- Chapter 13: Criticism of CAPM and Beta versus Other Risk Measures -- Introduction -- CAPM Assumptions and Beta as a Risk Measure -- Problems with CAPM Assumptions -- Testing Asset Pricing Models -- Testing Risk Factors Priced by the Market -- Risk Measures beyond Beta -- Total Risk -- Adjusted Beta for Company Size and Company-specific Risk -- Downside Risk -- Value at Risk -- Scenario-based Approach -- Duration -- Yield Spreads -- Fundamental Risk -- Summary -- Appendix 13A: Example of Computing Downside Beta Estimates -- Introduction -- Computing Downside Beta Estimates -- Chapter 14: Size Effect -- Introduction -- Size as a Predictor of Equity Returns -- The CRSP Databases -- Possible Explanations for the Greater Returns of Smaller Companies -- The Size Effect over Longer Time Periods -- The Size Effect Tends to Stabilize over Time -- The Size Effect: Empirical Evidence from Morningstar and Duff & Phelps Studies -- Morningstar Studies -- How Morningstar Size Premia Are Calculated -- Morningstar Size Premia Are "Beta Adjusted" -- Duff & Phelps Studies -- Additional Measures of Size -- How Duff & Phelps Size Premia Are Calculated -- Duff & Phelps Size Premia Are "Beta Adjusted" -- Duff & Phelps "Risk Premia over the Risk-free Rate" -- Estimating Size Premia for a Nonpublic Company -- Summary -- Chapter 15: Criticisms of the Size Effect -- Introduction.

Is the Size Effect the Result of Incorrectly Measuring Betas?.