How does market risk affect the cost of capital?

The chief way that market risk affects cost of capital is through its effect on the cost of equity. Companies finance operations and expansion projects with either equity or debt capital. Debt capital is raised by borrowing funds through various channels, primarily through acquiring loans or credit card financing. Equity financing is raised by selling shares of common or preferred stock.

A company's total cost of capital includes both the funds required to pay interest on debt funding and the dividends on equity funding. The cost of equity funding is determined by estimating the average return on investment that could be expected based on returns generated by the wider market. Therefore, because market risk directly affects the cost of equity funding, it also directly affects the total cost of capital.

The cost of equity funding is generally determined using the capital asset pricing model, or CAPM. This formula utilizes the total average market return and the beta value of the stock in question to determine the rate of return that stockholders might reasonably expect based on the perceived investment risk. The average market return is estimated using the rate of return generated by a major market index, such as the S&P 500 or the Dow Jones Industrial Average. The market return is further subdivided into the market risk premium and the risk-free rate.

The risk-free rate is estimated based on the rate of return of short-term Treasury bills, because these securities have stable values with guaranteed returns backed by the U.S. government. The market risk premium is equal to the market return minus the risk-free rate. This reflects the percentage of investment return that can be attributed to the stock market's volatility.

For example, if the current average rate of return for investments in the S&P 500 is 12% and the guaranteed rate of return on short-term Treasury bonds is 4%, then the market risk premium is 12% - 4%, or 8%.

The cost of equity capital, as determined using the CAPM method, is equal to the risk-free rate plus the market risk premium multiplied by the beta value of the stock in question. A stock's beta value is an important metric that reflects the volatility of a given stock relative to the volatility of the larger market. A beta value of 1 indicates that the stock in question is equally as volatile as the larger market. If the S&P 500 jumps 15%, the stock shows similar gains. Beta values between 0 and 1 indicate the stock is less volatile than the market, while values above 1 indicate greater volatility. A beta value of 0 indicates that the stock is completely stable.

Assume the stock in question has a beta value of 1.2, the Nasdaq generates average returns of 10% and the guaranteed rate of return on short-term Treasury bonds is 5.5%. Using the CAPM model, the rate of return that can reasonably be expected by investors is:

$\begin{aligned} &\text{Return} = 5.5\% + 1.2 \times (10\% - 5.5\%) = 10.9\% \\ \end{aligned}$​Return=5.5%+1.2×(10%−5.5%)=10.9%​

Using this method of estimating the cost of equity capital enables businesses to determine the most cost-effective means of raising funds, thereby minimizing the total cost of capital.