Friday, November 04, 2005

Cost of capital and CAPM

It was an interesting discussion in the Corp Finance class yesterday about the Capital structure and cost of capital (WACC, MCC, MM theory, etc), and one thing that came up was how leveraged betas are used to calculate the cost of equity. The procedure to estimate a company's beta, however seemed a bit convuluted. The beta is first calculated from historic data (which is also based on a host of fators like length of data considered, market indice considered, etc); but then apparently firms like Bloomberg or Barra weight the historical betas towards one to produce an adjusted "beta". I am not sure if this even makes any sense. I found this paper which sort of puts things in perspective and suggests alternatives for beta estimation based on operating and financial leverage ratios.

www.stern.nyu.edu/~adamodar/pdfiles/papers/beta.pdf

1 Comments:

Blogger shooGu said...

I agree, that bit about how beta's are calculated by Bloomberg et al was convoluted.

A tangential comment: it's been interesting to come across how influential CAPM has been on financial engineering. My impression is that Fischer Black's thinking was deeply influenced by CAPM, and more generally the ideas about equilibrium behind it. In fact, isn't that how he first arrived at the B-S equation?

Also, came across this profile of Rubinstein, which mentions a 1976 paper of his that relates CAPM to options pricing.

5:28 PM, November 07, 2005  

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