Growth Options, Beta, and the Cost of Capital∗

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 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%. ∗We thank Ravi Jagannathan, seminar participants at the Summer Research Conference 2004 at the Indian School of Business, and an anonymous referee for many insightful comments on previous drafts of the paper. All errors are ours. †Corresponding author: UCLA Anderson School, Los Angeles, CA 90095-1481, USA. ph: (310) 825-2198. e-mail: [email protected] ‡UCLA Anderson School, Los Angeles, CA 90095-1481, USA. §Goizueta Business School, Emory University, Atlanta, GA 30322, USA.