TABLE OF CONTENTS Statistician: A man who believes figures don t lie, but admits that under analysis some of them won t stand up either.
Evan Esar (1899 to 1995), Esar s Comic Dictionary
In Chapter Seven, we presented the general conceptual framework for the weighted average cost of capital (WACC) in the context of perfect capital markets. One of the most common methods for determining the appropriate value for the cost of capital is the capital asset pricing model (CAPM). Despite the many conceptual and empirical shortcomings of the CAPM, it is a useful framework for thinking about the estimation of the cost of capital for traded firms. In the previous chapters, we heroically assumed that the CAPM is a suitable model for estimating and calculating the cost of capital for traded firms.
The key idea is to calculate one of the following two parameters: e, the levered cost of equity or ?, the unlevered cost of equity. If the levered return e is known for a given period, the initial period, for instance, the unlevered return ? can be calculated. On the contrary, if the unlevered return ? is known, the levered return e can be calculated. Both the return to unlevered equity ? and the return to levered equity e cannot be independent variables. In other words, at the same time, we cannot have ? and e as inputs. For this reason several...
