The Entrepreneur's Cost of Capital: Incorporating Downside Risk

The capital asset pricing model (CAPM) suggests that an investor's cost of equity capital is determined by beta, a measure of systematic risk based on how returns co-move with the overall market. We propose to replace beta with downside beta, a measure more consistent with investors' perception of risk. Recent empirical evidence suggests that downside beta better captures the risk-return relationship in both emerging markets and developed markets. Grouping companies into industries by two-digit Standard Industrial Classification (SIC) code, we show that the average downside beta can be very different from traditional beta. We discuss the implications of using downside beta on valuation and provide a simple example to illustrate the application in valuation for both diversified and undiversified investors.

Contributor Notes

James T. Chong, PhD, is a Professor of Finance and Associate Director of the Center for Financial Planning and Investment at California State University, Northridge. He also serves as a Research Economist at MacroRisk Analytics. He received his PhD in Finance from the ICMA Centre, The University of Reading.

Yanbo Jin, PhD (corresponding author), is an Associate Professor of Finance and Director of the Center for China Finance and Business Research at California State University, Northridge. She received her PhD in Finance from University of California, Irvine.

G. Michael Phillips, PhD, is the Director of the Center for Financial Planning and Investment and a Professor of Finance, Financial Planning, and Insurance at California State University, Northridge. He also serves as Chief Scientist for MacroRisk Analytics. He received his PhD from the University of California, San Diego, with specializations in econometrics and applied economics.