Acknowledgements xiv
Introduction xv
Chapter 1 Cost of Capital Defined 1-1
Introduction 1-1
Income Approach Overview 1-2
Discounting versus Capitalizing Concepts 1-2
Valuation Date 1-5
Basic Cost of Capital Concepts 1-5
Sources of Capital 1-9
Cost of Capital Input Assumptions 1-10
Capital Structure Considerations 1-16
Calculating WACC 1-18
Estimates of Cost of Capital are Imprecise 1-19
Key Things to Remember about Cost of Capital 1-21
Chapter 2 Methods for Estimating the Cost of Equity Capital 2-1
Basic Framework 2-1
Types of Risk 2-6
Cost of Equity Capital Estimation Methods 2-8
Build-up 2-10
CAPM 2-11
Other Cost of Equity Capital Estimation Methods 2-15
Key Things to Remember about the Methods for Estimating the Cost of Equity Capital 2-17
Chapter 3 Basic Building Blocks of the Cost of Equity Capital– Risk-free Rate and Equity Risk Premium 3-1
The Risk-free Rate and Equity Risk Premium: Interrelated Concepts 3-1
Spot Risk-free Rates versus Normalized Risk-free Rates 3-2
Global Turbulence and Impact on Interest Rates 3-14
Methods of Risk-free Rate Normalization 3-19
Spot Yield or Normalized Yield? 3-23
Concluded Normalized Risk-free Rate 3-25
Equity Risk Premium 3-26
Estimating the Equity Risk Premium 3-27
Duff & Phelps Recommended U.S. ERP 3-38
Economic and Financial Market Indicators 3-39
Quantitative Models 3-44
Concluding on an ERP 3-48
Chapter 4 Basic Building Blocks of the Cost of Equity Capital – Size Premium 4-1
Size as a Predictor of Equity Returns 4-1
Possible Explanations for the Greater Returns of Smaller Companies 4-2
The Size Effect: Empirical Evidence 4-2
The Size Effect Over Longer Periods 4-3
The Size Effect Tends to Stabilize Over Time 4-6
The Size Effect Changes Over Time 4-7
Criticisms of the Size Effect 4-8
Data Issues 4-12
Has the Size Effect Disappeared in More Recent Periods? 4-17
Relationship of Size and Liquidity 4-21
Key Things to Remember about the Size Premium 4-26
Chapter 5 Basic Building Blocks of the Cost of Equity Capital – Betas and Industry Risk Premia 5-1
Beta 5-1
Differences in Estimation of Equity Betas 5-7
Full-Information Beta 5-11
Industry Risk Premia 5-12
Full-Information Beta Methodology 5-16
Debt Betas 5-17
Unlevering and Levering Equity Betas 5-18
Key Things to Remember about Betas and the Industry Risk Premia 5-19
Chapter 6 Basic Building Blocks of the Cost of Equity Capital – Company-specific Risk Premia 6-1
Introduction 6-1
Adjustments for Differences in Risk 6-2
Adjustments for Risk in Net Cash Flows and Biased Projections 6-5
Adjustments for Other Risk Factors 6-7
Matching Fundamental Risk and Return 6-8
Key Things to Remember about Company-specific Risk Premia 6-10
Chapter 7 The CRSP Deciles Size Premia Studies and the Risk Premium Report Studies– A Comparison 7-1
History of the CRSP Deciles Size Premia Studies 7-1
History of the Risk Premium Report Studies 7-2
Data Sources 7-2
Definitions of “Size” 7-6
Time Period Examined 7-7
Number of Portfolios 7-7
Portfolio Overlap 7-7
Guideline Portfolio Method and Regression Equation Method 7-8
Risk Premia Over CAPM (Size Premia) 7-8
“Smoothed” Premia versus “Average” Premia 7-12
OLS Beta versus Sum Beta 7-12
Risk Premia Over the Risk Free Rate 7-12
Unlevered Premia 7-13
Risk Study 7-13
Characteristics of Companies in Portfolios 7-13
Online Applications 7-14
Chapter 8 CRSP Deciles Size Premia Examples 8-1
Build-up Example 8-1
CAPM Example 8-4
Key Things to Remember about the CRSP Deciles Size Premia 8-7
Chapter 9 Risk Premium Report Exhibits – General Information 9-1
Appropriate Use of the Risk Premium Report Exhibits 9-1
How the Risk Premium Report Exhibits are Organized 9-2
Cost of Equity Capital Estimation Methods Available 9-3
Proper Application of the Equity Risk Premium (ERP) Adjustment 9-4
“Smoothed” Premia versus “Average” Premia 9-7
The “Guideline Portfolio Method” versus the “Regression Equation Method” 9-8
Example: Calculating an Interpolated Premium Using the Regression Equation Method 9-9
Tips Regarding the Regression Equation Method 9-10
Can the Regression Equation Method be Used If the Subject Company Is Small? 9-10
Size Study or Risk Study? 9-11
Key Things to Remember About the Risk Premium Report Exhibits 9-12
Chapter 10 Risk Premium Report Exhibits – Examples 10-1
Size Study 10-1
Reasons for Using Additional Measures of Size 10-1
The Difference Between the Size Study’s A Exhibits and the B Exhibits 10-2
The Difference Between “Risk Premia Over the Risk-free Rate” and “Risk Premia Over CAPM” 10-2
Calculating Custom Interpolated Premia for Smaller Companies 10-6
Overview of Methods Used to Estimate Cost of Equity Capital Using the Size Study 10-9
Size Study Examples: Assumptions Used 10-10
Size Study Examples 10-12
Unlevered Cost of Equity Capital 10-17
Overview of the Methodology and Assumptions Used to Unlever Risk Premia 10-18
Estimating Cost of Equity Capital Using the “Build-up 1-Unlevered” Method 10-22
Estimating Cost of Equity Capital Using the Capital Asset Pricing Model (CAPM) 10-26
Estimating Cost of Equity Capital Using the “Build-up 2” Method 10-30
Risk Study 10-35
Overview of Methods Used to Estimate Cost of Equity Capital Using the Risk Study 10-42
Risk Study Examples 10-45
Build-up 3-Unlevered 10-49
High-Financial-Risk Study 10-51
Overview of Methods Used to Estimate Cost of Equity Capital Using the High-Financial-Risk Study 10-57
Estimating Cost of Equity Capital Using the “Build-up 1-High-Financial-Risk” Method 10-58
Estimating Cost of Equity Capital Using the “CAPM-High-Financial-Risk” Method 10-61
Comparative Risk Study 10-63
Using the Comparative Risk Study to Refine Build-up Method Estimates 10-67
Using the Comparative Risk Study to Refine CAPM Estimates 10-69
Chapter 11 Real Estate 11-1
Individual Real Estate Assets 11-1
Real Estate Investment Trusts (REITs) 11-2
Structure of Real Estate Entities 11-3
Correlation of U.S. REITs Compared to Other U.S. Asset Classes 11-4
Summary Statistics of U.S. REITs Compared to Other U.S. Asset Classes 11-6
Real Estate Property Valuation Inputs 11-8
Key Things to Remember about Real Property Valuation 11-17
Chapter 12 Answers to Commonly Asked Questions 12-1
Glossary
Index
Appendix 1 – Definitions of Standard & Poor’s Compustat Data Items Used to Calculate the Risk Premium Report Exhibits
Appendix 2 – Changes to the Risk Premium Report Over Time
Appendix 3 – CRSP Deciles Size Premia Study: Key Variables
Appendix 3a – Industry Risk Premium (RPi)
Appendix 3b – Debt Betas
Appendix 4 – Risk Premium Report Study Exhibits
