Wednesday, August 10, 2011

Will the Real Capital Asset Pricing Model Please Stand Up? – Part Three

By the end of our last episode on this topic, we had 512 combinations of alternatives to arrive at our cost of capital, with the result being that we now have an unlevered cost of capital. Unlevered meaning no debt and no tax shield benefits in the capital structure.
We now decide how to re-lever this cost of capital to reflect our debt situation. Again there is choice, do we assume a debt weighting as it currently exists within our firm? Or do we use average weighting of a comparable set of companies? Or do we set a target (perhaps commensurate with a particular credit rating)? Arguments can be made for all three of these choices.
Using these three items as our only alternatives, we now have 1,536 possible combinations.
Cost of Debt
Finally, for cost of debt we also have several choices. Our actual cost of debt? Current debt rates for a firm of our credit capacity? Average debt rates over a historical period? Arguments again for all three.
We now have 4,608 possible combinations.
Other Items
For various purposes, we may decide to add some additional cost of capital elements. There exists research that argues for a small-cap premium to the cost of capital. Other models add a control premium if we are taking a controlling interest in an entity.
Generalizing our combination potential to additional items or no additional items, we have 9,216 possible cost of capital combinations.
This ends a three-part blog on choice alternatives for the cost of capital calculated using the CAPM. With almost 10,000 possible variations, we are in a position where we can potentially choose whichever number we like.
While this in not ideal to those who are desirous of a black-box outcome, for those who would like some “play” in the final figure this is an advantage. There are many levers to pull if we want to establish a higher or lower figure.
Ultimately, it thus comes down to a figure that the leaders of the firm a comfortable operating with. Know your customer.
I would love to hear your thoughts about the CAPM or your stories on this topic if you have them.
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