1. Introduction

The preceding section has shown that we need to estimate three parameters to estimate the appropriate risk-adjusted discount rate according to the Capital Asset Pricing Model (CAPM):

 

  • Risk-free rate of return (\(R_F\))
  • Market risk premium (\(MRP\))
  • Beta of the asset or project (\(\beta_j\))

 

With these ingredients, we can estimate the CAPM equation and find the model-implied discount rate \(k_j\):

 

\( k_j = R_F + \beta_j \times MRP \)

 

Note that the preceding sections have denoted the resulting expected return with the greek letter \(\mu\). We have used that letter to denote a theoretically expected value. Now that we switch to actual empirical estimates using real market data, we switch to the letter k to describe the estimated cost of capital. This terminology will accompany us throughout the remaining modules on this platform.

  

This section provides a brief overview of how to estimate the various ingredients of the CAPM.

 

Subsequently, we will address a few crucial implementation issues:

  • We will see that the procedure outlined above will generally yield the so-called cost of equity, i.e., the rate of return that shareholders expect to earn, on average. We show how to get from the cost of equity to the overall cost of capital (the cost of assets, kA), which reflects the required return on the firm's total capital.

  • Finally, we discuss how taxes affect our considerations and we present the weighted average cost of capital (WACC), which incorporates taxes in the discount rate.