We briefly summarize the model first presented by What's Your Real Cost of Capital?  By James J. McNulty, Tony D. Yeh, William S. Shulze, and Michael H. Lubatkin,  Harvard Business Review, October 2002.

The objective of this measure is to estimate cost of equity capital by examining the minimum return that would be acceptable to stockholders.

Consider corporate debt.  By comparing the price of the corporate debt to the price of the equivalent Treasury debt it is possible to infer the default risk premium from the relative values.  MCPM extends this idea to the risk of equity.

1.  Calculate the Forward Break-Even Price of the Stock.

This is defined as the minimal price an investor requires to be compensated for holding a stock as opposed to a bond.  Operationally, the return on equity equals

Calculate the minimal capital gains that stock investors require, which MCPM defines from the corporate debt yield.  From dividend policy and the observed corporate debt yield, the minimal capital gain rate is defined as follows:

And the forward break-even price is computed as follows:

Here P₀ equals the stock price and t is the investment time horizon in years.

2.        Estimate the Stock’s Return Volatility for the Given Time Horizon

This can be estimated using implied volatility from an at-the-money option price (if available) or past price data.  The implied volatility is preferred as it provides an ex ante estimate for volatility.

3.       Calculate the Cost of Downside Insurance

By combining the stock with a put option you can insure against downside losses.  MCPM computes the cost of the downside insurance by calculating the value of a put option with the life equal to the time horizon and strike equal to the forward break-even price. 

Note:  In this step if you apply an option calculator to calculate the put option value, the inputs into this calculation are the following:

·         underlying asset price= current market price of the stock

·         strike price =  forward break-even price (step 1 above)

·         time to maturity = investment horizon

·         volatility = stock’s volatility

·         risk free rate = the corporate debt rate for the time to maturity

·         dividend yield= dividend yield on the stock

 The Black-Scholes put option price is the estimate of the cost of insuring downside risk.

4.       Derive the annualized excess equity return

This step re-expresses the dollar cost of the insurance calculated in step 3 as an annualized rate.  This rate is the Excess Equity Return that will be added to the company’s bond rate to provide the volatility based estimate of the cost of equity capital.  The step is expressed as follows:

The intuition behind the above formula is as follows. The Option Price/Stock Price is proportion of the stock price that an investor would be willing to pay to buy out of the downside risk of earning a lower rate than the bond.  The Excess Equity Return is merely the re-expression of this proportion as an ordinary annuity using the standard annuity formula and solving for “C” when the PV of the annuity equals the Option Price/Stock Price.

Here, C is the Excess Equity Return and is obtained by solving this equation.

5.      The last step then combines the corporate debt rate with excess equity premium to provide the  MCPM estimate of the cost of equity capital.

In Valuation Tutor, you can see the details of this calculation and also compare the CAPM and MCPM.  After downloading the Current FTS Dataset, select Discount Rates under the Dividend Model and then MCPM: 

You can see we have selected the stock CMS Energy (CMS) to analyze.  This stock has a low beta (0.58 at the time of this writing) and a BBB credit rating.  The yield on its bonds with an average maturity of 10 years is 9.59%.  With an equity premium of 5.1%, the CAPM discount rate is 6.848%.  This is below the bond yield.  The MCPM discount rate as you can see is over 11%.