Cost of Capital: Applications and Examples, + Website, 5th Edition

PART TWO

Estimating the Cost of Equity Capital

INTRODUCTION

If one reads a typical corporate finance textbook, the theory of asset pricing (i.e., how the market prices risky assets) is expressed simply and clearly. The most widely taught theory, the capital asset pricing model (CAPM), is often presented as if it were the definitive, elegant solution to the issue. But academics and practitioners have discovered that the textbook formulas often do not reflect the market. The challenge we face is well expressed by John H. Cochrane, noted academic authority on asset pricing, in his presidential address on discount rates to the American Finance Association in January 2011:¹

In the beginning, there was chaos. Then came the CAPM. . . . Then anomalies erupted and there was chaos again. . . .

He goes on to describe some of the major differences researchers have observed between the market's pricing of risk and the theoretical pricing of risk as predicted by the CAPM. He summarizes the challenge:

. . . eventually, we have to connect all this back to the central question of finance, why do prices move?

The market reflects the varying behavior of investors—the market can be segmented and investors may not be fully diversified. These issues can create what some call anomalies leading researchers to develop multifactor models to incorporate how the market prices the different risk factors. That is, while the basic tenant of the pure CAPM (that all risk except beta risk can be diversified ...