Chapter 5: CONSTRAINED REGRESSION APPLICATION: COST OF CAPITAL

In this chapter, we extend the usage of CAPM to the problem of estimating the cost of capital in funding risky projects. This estimation involves the estimation of betas, which we had shown in the last chapter, as well as the estimation of market risk premium. The latter is a bit more tricky and sometimes requires auxiliary regressions involving constraining the intercept to be zero. The latter is the same as regression through the origin. Although constrained regression is more general and can apply to the constraint of any sets of coefficients in a linear regression equation, we consider only the case of regression through the origin here.