9-2 Measuring the Cost of Equity

After-tax Weighted-Average Cost of Capital

The cost of debt is always less than the cost of equity. The WACC formula blends the two costs. The formula is dangerous, however, because it suggests that the average cost of capital could be reduced by substituting cheap debt for expensive equity. It doesn’t work that way.

Adding debt

As the debt ratio D/V increases, the cost of the remaining equity also increases, offsetting the apparent advantage of more cheap debt.

Debt does have a tax advantage, however, because interest is a tax-deducible expense. That is why we use the after-tax cost of debt in the after-tax WACC.

Asset beta

The after-tax WACC depends on the average risk of the company’s assets, but it also depends on taxes and financing. It’s easier to think about project risk if you measure it directly. The direct measure is called the asset beta.

Calculating an asset beta is similar to calculating a weighted-average cost of capital. The debt and equity weights D/V and E/V are the same. The asset beta is an estimate of the average risk of a business.

When estimating the true beta we use past data. We set up a confidence interval ussing the standard error to estimate an indivdual assets beta. Although there almost always is a large margin of error the estimation errors tend to cancel out when you estimate betas of portfolios.

Only a portion of each stock’s total risk comes from movements in the market. The rest is firm-specific, diversifiable risk.