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Chapter 11

Cost of Capital

Overview

When estimating the cost of capital for a company in financial distress, the practitioner will need to de-
termine the rate of return that compensates investors for the level of risk associated with the projected or
promised future cash flows of the business or asset. Companies in financial distress typically have high-
er levels of risk associated with their future cash flows compared to similar companies not in financial
distress. The methodologies used to estimate the cost of capital for a distressed business are generally
the same as those used for other businesses. However, many practitioners advocate the need to incorpo-
rate the specific risks associated with financial distress into their cost of capital models in order to cap-
ture the operational risks faced by a company in financial distress. Other practitioners assert that compa-
ny-specific risk is not compensated by the market and the emphasis must be on properly "scrubbing"
forecasts in an effort to remove forecast bias.

In the next section, we discuss the approaches used to estimate each of these costs of capital and their
application to companies in financial distress.

Cost of Equity

The cost of equity is defined as the required rate of return by shareholders of the company. This is the
cost to a company that represents what the market demands (in the form of returns) in exchange for tak-
ing an ownership position and bearing the associated risk (over and above a risk-free asset). The most
widely used methods or models for estimating these costs are (1) the capital asset pricing model
(CAPM), (2) the build-up method, (3) the Duff & Phelps Risk Premium, and (4) the Fama-French three-
factor model. Each of these models is discussed in the following section.

CAPM

The most common method to calculate the cost of equity is the capital asset pricing model, or CAPM.
This model estimates the expected return of an asset (for instance, the common equity of a company) by
adding the current risk-free rate of return (typically a government-issued security) to the asset’s risk
premium. An asset’s risk premium is computed by multiplying the sensitivity of an asset’s expected ex-
cess returns to the expected excess returns of the market (also known as beta) fn 1 by the market premi-
um (expected returns of the market less the risk-free rate). For example, if the risk-free rate is 1%, the
Company A stock’s beta is .75, and the market premium is 8%, the CAPM for Company A’s equity is
estimated to be 7% (1% + .75(8%) = 7%).

fn 1 Beta is a statistical measurement that compares the volatility of an asset to the broader markets. It provides a way to gauge if an
asset will move with, opposite of, or independently of the markets as a whole as well as the magnitude of the change. This is also
known as nondiversifiable or systematic risk or, said another way, risk that cannot be minimized or reduced through diversification of
assets held in the portfolio. The higher the beta, the higher the expected return.

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