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Growth Options, Beta, and the Cost of Capital

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  • Antonio E. Bernardo
  • Bhagwan Chowdhry
  • Amit Goyal

Abstract

We show how to decompose a firm's beta into its beta of assets‐in‐place and its beta of growth opportunities. Our empirical results demonstrate that the beta of growth opportunities is greater than the beta of assets‐in‐place for virtually all industries over all periods of time dating back to 1977. The difference has important implications for determining the cost of capital. For example, when choosing comparables to determine a project beta one should match the growth opportunities of the project with those of the comparable firm. Assuming a 6% market equity risk premium, accounting for growth opportunities alters the project cost of capital by as much as 2% to 3%.

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  • Antonio E. Bernardo & Bhagwan Chowdhry & Amit Goyal, 2007. "Growth Options, Beta, and the Cost of Capital," Financial Management, Financial Management Association International, vol. 36(2), pages 1-13, July.
    • Handle: RePEc:bla:finmgt:v:36:y:2007:i:2:p:1-13
    DOI: 10.1111/j.1755-053X.2007.tb00084.x
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    Cited by:

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    2. Urbański, Stanisław & Zarzecki, Dariusz, 2022. "The Fama-French model for estimating the cost of equity capital: The impact of real options of investment projects," Economic Systems, Elsevier, vol. 46(1).
    3. Michalis Makrominas, 2017. "Recognized intangibles and the present value of growth options," Review of Quantitative Finance and Accounting, Springer, vol. 48(2), pages 311-329, February.
    4. David Yechiam Aharon & Yossi Yagil, 2019. "The Impact of Financial Leverage on Shareholders’ Systematic Risk," Sustainability, MDPI, vol. 11(23), pages 1-23, November.
    5. Cheng Wee Tan & Dogan Tirtiroglu & Ercan Tirtiroglu, 2013. "Reits' Growth Options and Asset Pricing Dynamics across Time," Koç University-TUSIAD Economic Research Forum Working Papers 1303, Koc University-TUSIAD Economic Research Forum.
    6. M. Cecilia Bustamante & Andres Donangelo, 2017. "Product Market Competition and Industry Returns," The Review of Financial Studies, Society for Financial Studies, vol. 30(12), pages 4216-4266.
    7. Urbański Stanisław & Leśkow Jacek, 2020. "Using the ICAPM to estimate the cost of capital of stock portfolios: empirical evidence on the Warsaw Stock Exchange," Statistics in Transition New Series, Polish Statistical Association, vol. 21(1), pages 73-94, March.
    8. Da, Zhi & Guo, Re-Jin & Jagannathan, Ravi, 2012. "CAPM for estimating the cost of equity capital: Interpreting the empirical evidence," Journal of Financial Economics, Elsevier, vol. 103(1), pages 204-220.
    9. Bustamante, Maria Cecilia & Donangelo, Andrés, 2014. "Product market competition and industry returns," LSE Research Online Documents on Economics 119031, London School of Economics and Political Science, LSE Library.
    10. Buchner, Axel, 2016. "Dealing with non-normality when estimating abnormal returns and systematic risk of private equity: A closed-form solution," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 45(C), pages 60-78.
    11. Sbuelz, Alessandro & Caliari, Marco, 2012. "Revisiting corporate growth options in the presence of state-dependent cashflow risk," European Journal of Operational Research, Elsevier, vol. 220(1), pages 286-294.
    12. Liu, Hao & Gao, Ya-Chun, 2019. "The impact of corporate lifecycle on Fama–French three-factor model," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 513(C), pages 390-398.
    13. Bressan, Silvia & Weissensteiner, Alex, 2021. "The financial conglomerate discount: Insights from stock return skewness," International Review of Financial Analysis, Elsevier, vol. 74(C).
    14. Dogan Tirtiroglu & Thu Ha Nguyen & Ercan Tirtiroglu & Tan Cheng Wee, 2017. "REITs, Growth Options and Beta," The Journal of Real Estate Finance and Economics, Springer, vol. 55(3), pages 370-394, October.
    15. Borgonovo, E. & Gatti, S. & Peccati, L., 2010. "What drives value creation in investment projects? An application of sensitivity analysis to project finance transactions," European Journal of Operational Research, Elsevier, vol. 205(1), pages 227-236, August.
    16. Coy, Jeffrey M. & Garcia-Feijoo, Luis, 2022. "Growth options, risk dynamics, and cost of capital: Evidence from U.S. corporate control transactions," The Quarterly Review of Economics and Finance, Elsevier, vol. 84(C), pages 562-576.
    17. Nicos Koussis & Michalis Makrominas, 2015. "Growth options, option exercise and firms’ systematic risk," Review of Quantitative Finance and Accounting, Springer, vol. 44(2), pages 243-267, February.
    18. Babak Jafarizadeh & Reidar B. Bratvold, 2019. "Exploration economics: taking opportunities and the risk of double-counting risk," Mineral Economics, Springer;Raw Materials Group (RMG);Luleå University of Technology, vol. 32(3), pages 323-335, November.
    19. Urbański Stanisław, 2021. "The Cost of Capital for Investment in the Warsaw Stock Exchange Indexes – Versus Djia," Folia Oeconomica Stetinensia, Sciendo, vol. 21(1), pages 122-143, June.
    20. Murad Antia & Christos Pantzalis & Jung Chul Park, 2021. "Does CEO myopia impede growth opportunities?," Review of Quantitative Finance and Accounting, Springer, vol. 56(4), pages 1503-1535, May.
    21. Liu, Hao & Zhang, Hao & Gao, Ya-Chun & Chen, Xu-Dong, 2022. "Firm age and beta: Evidence from China," International Review of Economics & Finance, Elsevier, vol. 77(C), pages 244-261.
    22. Amit Goyal, 2012. "Empirical cross-sectional asset pricing: a survey," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 26(1), pages 3-38, March.
    23. Stanisław Urbański & Jacek Leśkow, 2020. "Using the ICAPM to estimate the cost of capital of stock portfolios: empirical evidence on the Warsaw Stock Exchange," Statistics in Transition New Series, Polish Statistical Association, vol. 21(1), pages 73-94, March.

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