COMM 370 - Corporate Finance
Class 6: Cost of Capital of the
Unlevered Firm
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Class 6: Cost of Capital of the Unlevered Firm
Learning objectives:
• Explain what systematic risk is and how it affects a project’s cost of capital
• Recognize “beta” as a measure of systematic risk
• Demonstrate how to use betas to estimate a project or firm’s CAPM cost of capital
Outline:
• Firm-specific vs. systematic risk
• Measuring systematic risk with beta
• CAPM and the risk premium
• Application: Cost of Capital for Lululemon
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Current Focus: an Unlevered Firm
• Examples of unlevered (or all-equity) firms include:
• Lululemon Athletica
• Chipotle Mexican Grill
• Microsoft until 2009
• Apple until 2013
• Nathan’s Famous until 2014
• Such firms are not committed to regular interest payments and thus have no financial
leverage → with no “financial risk” they only have “business risk”.
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Intuition on Cost of Capital - Refresher
• A firm is considering a project that costs C0 and generates a risky future free cash flow.
• What is the annual cost of raising the funds from equity investors?
• investors can invest in an equally risky market instrument with an expected return
r, so they require the same expected return on the project’s equity.
• the firm must sell the shares at a price low enough to give investors an expected
return of r on their equity investment.
• If discounting the project’s free cash flow at r gives NPV>0, it means that the project
creates value after fairly rewarding investors for the risk they take.
• The cost of capital of a project is the opportunity cost for investors of investing in the
project instead of investing in a market opportunity with similar risk.
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Firm-Specific vs. Systematic Risk
• The cost of capital is the expected return investors require in compensation for the
funds they supply to the firm, and depends on the amount of risk they must bear.
• An investment in a company’s stock is exposed to two different types of risk, and
distinguishing between these risk is fundamental in finance applications:
• Firm-specific or idiosyncratic risk:
• returns vary due to company-specific news
• this risk is independent or uncorrelated across stocks
• Market or systematic risk:
• returns vary due to market-wide news (about the economy in general)
• this risk affect all stocks simultaneously
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Firm-Specific vs. Systematic Risk - Examples
• Idiosyncratic risks:
• risk of a product liability lawsuit
• risk that the CEO or top talent would leave
• risk that employees will go on strike for a few days
• Systematic risks:
• risk that a world war will slow down the economy
• risk that the Bank of Canada will increase interest rates
• risk that oil prices increase and increase production costs in the economy
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Firm-Specific vs. Systematic Risk – Effect on Cost of Capital
• Should investors be rewarded with a higher expected return for both idiosyncratic
and systematic risk? No! They should be compensated only for systematic risk!
• Why? Investors can “diversify away” the stock’s idiosyncratic risk, by spreading their
investment across many stocks – buy the market portfolio for full diversification.
• idiosyncratic events will only affect one or few firms at a time
• with small weights in each stock, the impact on portfolio returns is negligible
→ a firm’s idiosyncratic risk does not affect the firm’s cost of capital!
• But investors must bear the firm’s systematic risk (which is undiversifiable!):
→ they demand higher return in compensation for systematic risk!
→ a firm’s systematic risk is the key driver of its cost of capital!
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Measuring Systematic Risk with Beta
• We want to isolate the average change in a stock’s expected return for a 1% change
in the expected return of a portfolio that fluctuates only due to systematic risk.
• Because the “market portfolio” contains all stocks, it is very well diversified, and its
return varies only due to systematic risk.
• We really need the World Index – full diversification – but:
• in the US, the S&P 500 Index
• in Canada, the S&P / TSX Composite Index
• side note: is a country’s market portfolio really well diversified?
• Beta (β ) is the expected % change in the excess return of a security for a 1% change
in the excess return of the market portfolio – measures systematic risk.
• You are not required to estimate β in this course, but see the Appendix at the end of
the notes for a brief summary. The estimation of beta is discussed in COMM 371.
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Beta, CAPM, & the Cost of Capital
• The cost of capital 𝒓𝒓𝒊𝒊 for a firm or project i depends on the risk-free rate (reward for
the time value of money) and a risk premium (reward for its systematic risk).
• The Capital Asset Pricing Model (CAPM) cost of capital ri is:
𝑟𝑟𝑖𝑖 = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑖𝑖 𝐸𝐸[𝑅𝑅𝑀𝑀]– 𝑟𝑟𝑓𝑓 , where
• 𝑟𝑟𝑖𝑖 is the cost of capital (or expected return) for stock i, where 𝒓𝒓𝒊𝒊 = 𝑬𝑬[𝑹𝑹𝒊𝒊]
• 𝑟𝑟𝑓𝑓 is the risk-free rate
• 𝐸𝐸[𝑅𝑅𝑀𝑀] is the expected return on the stock market
• 𝛽𝛽𝑖𝑖 is the beta of the firm’s stock indexed by i
• 𝛽𝛽𝑖𝑖 𝐸𝐸[𝑅𝑅𝑀𝑀]– 𝑟𝑟𝑓𝑓 is the stock’s risk premium
• Graham (2022) indicates that 83% of CFOs use CAPM; some others use multifactor
models (63%) and average stock returns (33%).
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
What Drives the Risk Premium?
• The risk premium is: 𝒓𝒓𝒊𝒊 − 𝒓𝒓𝒇𝒇 = 𝜷𝜷𝒊𝒊 𝑬𝑬[𝑹𝑹𝑴𝑴]– 𝒓𝒓𝒇𝒇
• The risk premium is higher when the market risk premium, 𝑬𝑬[𝑹𝑹𝑴𝑴]– 𝒓𝒓𝒇𝒇 , is higher.
This is the compensation to investors for the average riskiness of the stock market.
• Given a market risk premium, an asset i requires a higher risk premium if its 𝜷𝜷𝑖𝑖 is
higher (βi > 1 and βi < 1 indicate more and less risky than the market portfolio).
• A stock’s beta is higher if the firm has higher systematic risk, i.e., if the firm is more
sensitive to fluctuations in market-wide conditions due to higher:
• Business risk
• it operates a very cyclical business
• high fixed costs (operating leverage)
• Financial risk (leverage amplifies business risk; more on this later)
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
5-Year Market Betas 2017 2018 2019 2020 2021 2022
Selected American Companies
Amazon 1.37 1.58 1.41 1.11 1.06 1.20
Apple 1.07 1.16 1.18 1.19 1.14 1.21
Boeing 1.17 1.17 1.15 1.58 1.48 1.40
Coca-Cola 0.59 0.53 0.34 0.52 0.62 0.52
Microsoft 0.83 1.12 1.12 0.76 0.82 0.90
United Airlines 1.03 0.82 1.10 1.56 1.44 1.32
Selected Canadian Companies
Canadian National Railway 1.03 1.00 0.96 0.78 0.78 0.86
Celestica Inc 0.76 0.81 0.87 2.37 2.33 1.95
Davids Tea - - - 3.21 3.31 2.71
Enbridge 0.58 0.50 0.61 0.78 0.87 0.81
Rogers Communications 0.85 0.62 0.46 0.45 0.48 0.47
SHOPIFY INC - - - 1.50 1.40 1.89
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
What Risk-Free Rate?
• The CAPM cost of capital is 𝑟𝑟𝑖𝑖 = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑖𝑖 𝐸𝐸[𝑅𝑅𝑀𝑀]– 𝑟𝑟𝑓𝑓 .
• The current risk-free rate rf (first term) captures the time-value of money:
• use 3-month, 1-year, 5-year, 10-year, 20-year, or 30-year T-Bill rate?
• if the yield curve is flat, the choice is unimportant; otherwise it matters
• typically pick the maturity that matches the maturity of the project
• the 5-year and 10-year risk-free rates are the most commonly used
• Everything else the same, changes in the risk-free rate lead to changes in the CAPM
cost of capital, i.e., higher (lower) when rf is higher (lower).
• The historical average rate for 10-year T-Bills over 1954-2022 is about 5.6%, but with
large variation over time, e.g., almost 14% in 1981 and only 0.9% in 2020.
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
How to Calculate the Market Risk Premium, E(RM) – rf?
• Approach 1: compute historical average of (RM – rf) ; (same as avg RM – avg rf).
• Approach 2: compute historical average of RM and subtract the current rf.
• The approaches are equivalent if the current rf equals the historical average rf, but:
• if current rf < historical average rf → approach 2 gives a higher premium
• if current rf > historical average rf → approach 2 gives a lower premium
• Approach 1 is fine if RM – rf is constant over time; but the average premium is lower
(higher) in periods of high (low) interest rates, so people make ad-hoc adjustments.
• Approach 2 helps in that the historical average of RM is more stable over various
periods, giving a larger risk premium when rf is low and a smaller one when rf is high.
• We will use approach 2 in this course but the other approach is also widely used.
• The average market risk premium over 1954-2022 is about is about 3.3%, but with
large variation over time, e.g., about 2.5% in the 1980s and about 9.2% in the 2010s.
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Application: Estimating Lululemon’s Cost of Capital
• Suppose that in Jan 2024 Lululemon is considering a new project in the same line of
business (e.g., a new store in Toronto). What is the cost of capital for the project?
• The project has similar risk as Lulu’s main operations, so we can use its cost of capital
estimated as of Dec 2023 to discount its free cash flow (recall Lulu has no debt).
• What is your “guesstimate” of Lulu’s equity beta? And its cost of capital?
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Application: Estimating Lululemon’s Cost of Capital (Cont.)
• Risk free rate (rf): 10 Year T-Bill rate (source: FRED Database) ; 4.5% in Nov 2023
• Beta (βi): beta from Yahoo Finance ; 1.35 in Nov 2023
• E(RM): Avg of S&P 500 return over 1950-2022: 9.1%
• Lulu’s CAPM cost of capital as of Dec 2023:
rLulu = 4.5% + 1.35×(9.1% - 4.5%) = 10.71%
• Discussion:
• we used the 10-year rf, but could use the 20-year rate (depending on project)
• we used the S&P 500 index as proxy for market, but excluded smaller stocks
• averaged S&P 500 index returns over 1950-2022, but could go back to 1925
• Approach 1 with a market risk premium of 4.6% gives the same result
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Summary
• The cost of capital of a project is the opportunity cost for investors of investing in the
project instead of investing in a market opportunity with similar risk.
• Investors can “diversify away” idiosyncratic risk but must bear systematic risk → they
receive higher return in compensation for systematic risk only.
• Beta (β) measures the sensitivity of a stock’s excess return to changes in the excess
return of the market portfolio – it captures systematic risk.
• Beta can be estimated using the prior history of stock and market returns; usually
using past 3 or 5 years of monthly returns.
• The widely-used CAPM cost of capital is: ri = rf + βi (E[RM] – rf)
• Note that βi is the only thing that differs across stocks.
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Class Activity: Betas of Similar Companies
Use Yahoo Finance (statistics tab) to complete the table:
Company Market Cap ($Bn) Total Debt ($Bn) D/V 5-year Beta
Coca Cola Co (KO)
PepsiCo Inc (PEP)
Any thoughts?
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Class Activity: Betas of Different Companies
Use Yahoo Finance (statistics tab) to find the betas of:
• Alcoa Corp (AA) – major American producer of aluminum:
• Barrick Gold Corp (GOLD) – major Canadian gold mining company:
What explains the large differences in betas?
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Class Activity: The Implied Cost of Capital (ICC)
• Information about the firm:
• the current share price is $23
• next year’s dividend per share is $1.25
• the dividend is expected to grow 5% annually afterwards
• What is the firm’s cost of capital implied (rE) by the current share price, next year’s
dividend and the dividend’s expected subsequent growth?
• Hint: perpetual growth formulas apply here!
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Optional Appendix:
Estimation of Beta using Historical Returns
• The estimation of betas is covered in detail in COMM 371 and COMM 374, which all
finance students take but other students don’t take.
• In this course, you are not required to estimate betas, so not a problem.
• Still, the next two slides give a summary in case you are interested.
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Estimation of Beta using Historical Returns
• Conceptually we want the stock’s future beta, but in practice we estimate the stock’s
historical beta using the prior history of stock and market returns.
• This assumes that current or recent betas are good estimates of future ones!
• Use linear regression to estimate:
(Ri – rf) = αi + βi (RM – rf) + εi ; where E(εi) = 0
• Data requirements:
• the firm’s stock returns
• the risk-free rate
• the return on the market portfolio
• Software? Many options, but even Excel can do it!
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
Estimation of Beta using Historical Returns (Cont.)
• Key practical choices:
• data frequency (daily, weekly, or monthly)
• estimation window (past 6 months, past 3 years, 5 years, or 10 years)
• Tradeoffs:
• longer estimation windows (10 years vs. 3 years) give more precise estimates
• but a firm’s beta can change over time; using data too far back is undesirable
• could use higher frequency data (e.g., daily or weekly vs. monthly) to increase
sample size while keeping a short estimation window of 3 years
• however, daily returns tend to be noisy, and this can affect estimates
• How to obtain accurate estimates of β is a science on its own!
The University of British Columbia | Sauder School of Business | COMM 370 2023 Winter Term 2 | Do not post without permission
