16/12/2019 How does market risk affect the cost of capital?

TRADING SKILLS & ESSENTIALS RISK MANAGEMENT

How does market risk affect the cost of

capital?

BY CLAIRE BOYTE-WHITE | Updated Oct 21, 2019

Cost of capital is the return that is necessary for a company to invest in a major project like
building a plant or factory. To optimize profitability, a company will only invest or expand
operations when the projected returns from a project are greater than the cost of capital,
which includes both debt and equity. Debt capital is raised by borrowing funds through
various channels, such as acquiring loans or credit card financing. On the other hand, equity
financing is the act of selling shares of common or preferred stock. The primary way that
market risk affects cost of capital is through its effect on cost of equity.

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Understanding Cost of Capital

A company's total cost of capital includes both the funds required to pay interest on debt
financing and the dividends on equity funding. The cost of equity funding is determined by
estimating the average return on investment that could be expected based on returns
generated by the wider market. Therefore, because market risk directly affects the cost of
equity funding, it also directly affects the total cost of capital.

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KEY TAKEAWAYS
Cost of capital refers to the return required to make a company's capital investment
project worthwhile.
Cost of capital includes debt financing and equity funding.
Market risk affects cost of capital through the costs of equity funding.
Cost of equity is typically viewed through the lens of CAPM.
Estimating cost of equity can help companies minimize total cost of capital, while
giving investors a sense of whether or not expected returns are enough to
compensate for the risk.

The cost of equity funding is generally determined using the capital asset pricing model, or
CAPM. This formula utilizes the total average market return and the beta value of the stock in
question to determine the rate of return that stockholders might reasonably expect based on
the perceived investment risk. The average market return is estimated using the rate of
return generated by a major market index, such as the S&P 500 or the Dow Jones Industrial
Average. The market return is further subdivided into the market risk premium and the risk-
free rate.

The risk-free rate of return is typically estimated using the rate of return of short-term
Treasury bills because these securities have stable values with guaranteed returns backed by
the U.S. government. The market risk premium is equal to the market return minus the risk-
free rate and reflects the percentage of investment return that can be attributed to stock
market volatility.

For example, if the current average rate of return for investments in the S&P 500 is 12% and
the guaranteed rate of return on short-term Treasury bonds is 4%, then the market risk
premium is 12% - 4%, or 8%.
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Computing Cost of Capital with CAPM

The cost of equity capital, as determined by the CAPM method, is equal to the risk-free rate
plus the market risk premium multiplied by the beta value of the stock in question. A stock's
beta is a metric that reflects the volatility of a given stock relative to the volatility of the
larger market.

A beta value of 1 indicates that the stock in question is equally as volatile as the larger
market. If the S&P 500 jumps 15%, for instance, the stock is expected to show similar 15%
gains. Beta values between 0 and 1 indicate the stock is less volatile than the market, while
values above 1 indicate greater volatility.

Assume a stock has a beta value of 1.2, the Nasdaq generates average returns of 10%, and
the guaranteed rate of return on short-term Treasury bonds is 5.5%. The rate of return that
can reasonably be expected by investors can be computed using the CAPM model:

Return = 5.5% + 1.2 × (10% − 5.5%) = 10.9%

Using this method of estimating the cost of equity capital enables businesses to determine
the most cost-effective means of raising funds, thereby minimizing the total cost of capital.
From the perspective of the investor, the results can help decide whether the expected
return justifies investment given the potential risk.

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How Do I Use the CAPM to Determine Cost of Equity?

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How is the capital asset pricing model (CAPM)

represented in the security market line (SML)?

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Partner Links

Related Terms
Capital Asset Pricing Model (CAPM)
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The Capital Asset Pricing Model is a model that describes the relationship between risk and expected
return, helping in the pricing of risky securities. more

Country Risk Premium (CRP) Definition

Country Risk Premium (CRP) is the additional return or premium demanded by investors to
compensate them for the higher risk of investing overseas. more

Security Market Line (SML)

The security market line (SML) is a line drawn on a chart that serves as a graphical representation of
the capital asset pricing model. more

Cost of Equity
The cost of equity is the rate of return required on an investment in equity or for a particular project or
investment. more

How the Consumption Capital Asset Pricing Model Works

The consumption capital asset pricing model is an extension of the capital asset pricing model that
focuses on a consumption beta instead of a market beta. more

International Capital Asset Pricing Model (CAPM)

The international capital asset pricing model (CAPM) is a financial model that extends the concept of
the CAPM to international investments. more

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