Did Professor Willard Carleton do a reasonable job of estimating the cost of common equity for Communications Satellite Corporation for 1964 - 1975?


Debt Equity Risk Premium

        The financial framework used by Dr. Willard T. Carleton is the Debt Equity Risk Premium (DERP).  The cost of equity equals the cost of debt plus an equity risk premium and is represented by the following equation:

Ke = Kd + ERP

Cost of Debt

As shown above, the DERP model uses a firm’s cost of debt as a starting point for the formula and adds a risk premium to it to determine the appropriate cost of equity.  When the company has no debt to establish a starting point, the risk-free rate may be used instead, but to some disadvantage.  There are similarities and differences between the risk-free rate of return and the cost of debt.  They both account for the rate of inflation and long-term rates include a maturity risk premium.  The cost of debt also includes a risk premium for the risk of liquidity, marketability, and default that is not a part of the risk-free rate.  Government bonds can be used to determine the appropriate risk-free rate.  Either T-bonds or T-bills can be used for this determination.  The length of the project should play a part in deciding which Treasury instrument to use.  When dealing with short-term rates, liquidity and marketability risks are typically increased, but default, maturity, and inflation risks are usually decreased.  

Although the risk-free rate can be used as an estimated starting point for the Debt Equity Risk Premium framework, a company will have some degree of liquidity, marketability, and default risk not represented by a government rate.  Because of this, using the risk-free rate is not always an accurate predictor of a firm’s cost of equity.  Using the firm’s cost of debt is preferable to using the risk-free rate because it more accurately reflects the true financial risks faced by the company.

Equity Risk Premium

Based on the idea that an investor requires a high rate of return for assuming risk, a risk premium is added to the cost of debt.   The risk premium is the difference between the cost of debt and the required return an investor would expect to take on greater risk.  

The risk premium is usually determined a number of ways.  One way to identify the risk premium is to take a historical average of the spread between the cost of debt and the return on equity.  The use of historical risk premiums requires the assumption that current risk premium expectations are equal to the historical values chosen.  Another way to find this premium is to survey portfolio managers about their spread in expected returns between stocks and bonds.  A third way to calculate the risk premium is to use the spread of a comparable company.  According to Brigham and Houston, the typical risk premium usually falls between three to five percent. 

The difficulty with determining a risk premium is that business and financial risks vary according to time and industry.  Premiums are also affected by investors’ risk aversion.  These problems with calculating the risk premium create a greater degree of variability.

The equity risk premium added to a risk-free security is not the same as the premium used with a corporate bond.    Exhibit 1 shows the difference between these premiums.  Equity risk premium 1, added to the risk-free rate, includes a corporate bond risk premium and equity risk premium 2.  This is due to greater degrees of risk for different types of investments.  

Comparable Companies

When a company has not used debt financing to determine a cost of debt, instead of using the risk-free rate as a substitute, a firm can look to comparable companies as a possible alternative.  No two companies will have the same risk factors or capital structure, but competitors within the same industry or facing the same degree of government regulation are optimal starting points.  Another aspect of a firm's cost of debt with respect to comparables is its bond rating.  Finding a company that has a comparable bond rating will provide insight as to the amount of debt to be used.  Companies with matching bond ratings reflect similar financial risk.  Since it is financial risk that drives default, marketability, and liquidity risk premiums, this makes an appropriate comparable an adequate predictor of the actual costs of debt expected.  

Not only can comparables be used to determine the cost of debt, but they can also help establish a benchmark for finding an equity risk premium.  An ideal comparable would have the same degree of business and financial risk and will reflect this in its risk premium.  One way of identifying similar risks is by comparing companies’ beta values.  A beta value represents the volatility and sensitivity to changes in stock price.  When comparing companies this way it is important to determine whether a beta value is leveraged or not.  A leveraged beta has been modified to include a firm’s expected debt.  Only by comparing two leveraged or two unleveraged beta’s can an accurate comparison be made.  For formulas on calculating a leveraged or unleveraged beta, see Exhibit 2.

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Not all companies make good comparables.  There are some industries that have unusual and uncontrollable factors (like the utility industry).  Due to government involvement, subsidies, unfair or illegal market practices, or other factors, these companies should not be used as comparables.  The biggest advantage to using a comparable is that they share many of the same business risk factors, especially if they are within the same industry.  Ideally, a good comparable would be in the same industry, have a matching bond rating and beta values, and operate in the same time period.  A comparable like this would reflect both financial ...

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