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 © CFA Institute. For candidate use only. Not for distribution.

CORPORATE ISSUERS,
EQUITY INVESTMENTS,
FIXED INCOME

CFA® Program Curriculum

2023 • LEVEL 1 • VOLUME 4
© CFA Institute. For candidate use only. Not for distribution.

©2022 by CFA Institute. All rights reserved. This copyright covers material written
expressly for this volume by the editor/s as well as the compilation itself. It does
not cover the individual selections herein that first appeared elsewhere. Permission
to reprint these has been obtained by CFA Institute for this edition only. Further
reproductions by any means, electronic or mechanical, including photocopying and
recording, or by any information storage or retrieval systems, must be arranged with
the individual copyright holders noted.
CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the
trademarks owned by CFA Institute. To view a list of CFA Institute trademarks and the
Guide for Use of CFA Institute Marks, please visit our website at www.cfainstitute.org.
This publication is designed to provide accurate and authoritative information
in regard to the subject matter covered. It is sold with the understanding that the
publisher is not engaged in rendering legal, accounting, or other professional service.
If legal advice or other expert assistance is required, the services of a competent pro-
fessional should be sought.
All trademarks, service marks, registered trademarks, and registered service marks
are the property of their respective owners and are used herein for identification
purposes only.
ISBN 978-1-950157-99-0 (paper)
ISBN 978-1-953337-26-9 (ebook)
2022
 © CFA Institute. For candidate use only. Not for distribution.

CONTENTS

How to Use the CFA Program Curriculum   xiii

Errata   xiii
Designing Your Personal Study Program   xiii
CFA Institute Learning Ecosystem (LES)   xiv
Feedback   xiv

Corporate Issuers

Learning Module 1 Cost of Capital-Foundational Topics   3

Introduction   3
Cost of Capital   4
Taxes and the Cost of Capital   6
Costs of the Various Sources of Capital   7
Cost of Debt   7
Cost of Preferred Stock   10
Cost of Common Equity   12
Estimating Beta   16
Estimating Beta for Public Companies   16
Estimating Beta for Thinly Traded and Nonpublic Companies   17
Flotation Costs   20
Methods in Use   23
Summary   24
References   26
Practice Problems   27
Solutions   34

Learning Module 2 Capital Structure   39

Introduction   39
Factors Affecting Capital Structure   40
Internal Factors Affecting Capital Structure   41
Existing leverage   44
External Factors Affecting Capital Structure   49
Capital Structure and Company Life Cycle   51
Background   51
Start-Ups   52
Growth Businesses   53
Mature Businesses   54
Unique Situations   56
Modigliani–Miller Propositions   58
MM Proposition I without Taxes: Capital Structure Irrelevance   59
MM Proposition II without Taxes: Higher Financial Leverage Raises
the Cost of Equity   59
MM Propositions with Taxes: Firm Value    62
MM Propositions with Taxes: Cost of Capital   63
Costs of Financial Distress   65

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iv Contents

Optimal and Target Capital Structures   66

Market Value vs. Book Value   68
Target Weights and WACC    69
Pecking Order Theory and Agency Costs   70
Stakeholder Interests   72
Debt vs. Equity Conflict   73
Preferred Shareholders   78
Management and Directors   78
Summary   80
References   81
Practice Problems   82
Solutions   87

Learning Module 3 Measures of Leverage   91

Introduction   91
Leverage   92
Business and Sales Risks   94
Business Risk and Its Components   94
Sales Risk   95
Operating Risk and the Degree of Operating Leverage   96
Financial Risk, the Degree of Financial Leverage and the Leveraging Role
of Debt   103
Total Leverage and the Degree of Total Leverage   107
Breakeven Points and Operating Breakeven Points   109
The Risks of Creditors and Owners   112
Summary   113
Practice Problems   115
Solutions   120

Equity Investments

Learning Module 1 Market Organization and Structure   125

Introduction   126
The Functions of the Financial System   126
Helping People Achieve Their Purposes in Using the Financial System   127
Determining Rates of Return   132
Capital Allocation Efficiency   133
Assets and Contracts   134
Classifications of Assets and Markets   135
Securities   137
Fixed Income   137
Equities   138
Pooled Investments   139
Currencies, Commodities, and Real Assets   140
Commodities   141
Real Assets   141
Contracts   144
Forward Contracts   145
Futures Contracts   146

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Contents v

Swap Contracts   147

Option Contracts   148
Other Contracts   149
Financial Intermediaries   149
Brokers, Exchanges, and Alternative Trading Systems   150
Dealers   151
Arbitrageurs   152
Securitizers, Depository Institutions and Insurance Companies   154
Depository Institutions and Other Financial Corporations   156
Insurance Companies   157
Settlement and Custodial Services and Summary   158
Summary    160
Positions and Short Positions   161
Short Positions   162
Leveraged Positions   163
Orders and Execution Instructions   166
Execution Instructions   167
Validity Instructions and Clearing Instructions   171
Stop Orders   171
Clearing Instructions   173
Primary Security Markets   173
Public Offerings   173
Private Placements and Other Primary Market Transactions   175
Importance of Secondary Markets to Primary Markets   177
Secondary Security Market and Contract Market Structures   177
Trading Sessions   177
Execution Mechanisms   178
Market Information Systems   181
Well-functioning Financial Systems   182
Market Regulation   184
Summary   187
Practice Problems   190
Solutions   198

Learning Module 2 Security Market Indexes   203

Introduction   203
Index Definition and Calculations of Value and Returns   204
Calculation of Single-Period Returns   205
Calculation of Index Values over Multiple Time Periods   207
Index Construction   208
Target Market and Security Selection   209
Index Weighting   209
Index Management: Rebalancing and Reconstitution   218
Rebalancing   218
Reconstitution   218
Uses of Market Indexes   220
Gauges of Market Sentiment   220
Proxies for Measuring and Modeling Returns, Systematic Risk, and
Risk-Adjusted Performance   220

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vi Contents

Proxies for Asset Classes in Asset Allocation Models   221

Benchmarks for Actively Managed Portfolios   221
Model Portfolios for Investment Products   221
Equity indexes   222
Broad Market Indexes   222
Multi-Market Indexes   222
Sector Indexes   224
Style Indexes   224
Fixed-income indexes   225
Construction   225
Types of Fixed-Income Indexes   225
Indexes for Alternative Investments   228
Commodity Indexes   228
Real Estate Investment Trust Indexes   228
Hedge Fund Indexes   229
Summary   231
Practice Problems   233
Solutions   240

Learning Module 3 Market Efficiency   245

Introduction   245
The Concept of Market Efficiency   247
The Description of Efficient Markets   247
Market Value versus Intrinsic Value   249
Factors Affecting Market Efficiency Including Trading Costs   250
Market Participants   251
Information Availability and Financial Disclosure   252
Limits to Trading   253
Transaction Costs and Information-Acquisition Costs   253
Forms of Market Efficiency   255
Weak Form   255
Semi-Strong Form   256
Strong Form   259
Implications of the Efficient Market Hypothesis   259
Fundamental Analysis   259
Technical Analysis   260
Portfolio Management   260
Market Pricing Anomalies - Time Series and Cross-Sectional   261
Time-Series Anomalies   262
Cross-Sectional Anomalies   264
Other Anomalies, Implications of Market Pricing Anomalies   264
Closed-End Investment Fund Discounts   265
Earnings Surprise   265
Initial Public Offerings (IPOs)   266
Predictability of Returns Based on Prior Information   267
Implications for Investment Strategies   267
Behavioral Finance   268
Loss Aversion   268
Herding   268

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Contents vii

Overconfidence   269
Information Cascades   269
Other Behavioral Biases   270
Behavioral Finance and Investors   270
Behavioral Finance and Efficient Markets   270
Summary   271
References   272
Practice Problems   274
Solutions   278

Learning Module 4 Overview of Equity Securities   281

Importance of Equity Securities   281
Equity Securities in Global Financial Markets   282
Characteristics of Equity Securities   287
Common Shares   288
Preference Shares   290
Private Versus Public Equity Securities   292
Non-Domestic Equity Securities   295
Direct Investing   296
Depository Receipts   297
Risk and Return Characteristics   300
Return Characteristics of Equity Securities   300
Risk of Equity Securities   301
Equity and Company Value   302
Accounting Return on Equity   303
The Cost of Equity and Investors’ Required Rates of Return   307
Summary   309
References   311
Practice Problems   312
Solutions   316

Learning Module 5 Introduction to Industry and Company Analysis   319

Introduction   320
Uses of Industry Analysis   320
Approaches to Identifying Similar Companies   321
Products and/or Services Supplied   321
Business-Cycle Sensitivities   322
Statistical Similarities   323
Industry Classification Systems   324
Commercial Industry Classification Systems   325
Constructing a Peer Group   329
Describing and Analyzing an Industry and Principles of Strategic Analysis   334
Principles of Strategic Analysis   335
Barriers to Entry   336
Industry Concentration   338
Industry Capacity   340
Market Share Stability   342
Price Competition   343
Industry Life Cycle   344

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viii Contents

External Influences on Industry   348

Macroeconomic Influences   348
Technological Influences   349
Demographic Influences   350
Governmental Influences   350
Social Influences   351
Environmental Influences   352
Industry Comparison   355
Company Analysis   357
Elements That Should Be Covered in a Company Analysis   358
Spreadsheet Modeling   360
Summary   361
References   365
Practice Problems   366
Solutions   371

Learning Module 6 Equity Valuation: Concepts and Basic Tools   375

Introduction   376
Estimated Value and Market Price   376
Categories of Equity Valuation Models   378
Background for the Dividend Discount Model   380
Dividends: Background for the Dividend Discount Model   380
Dividend Discount Model (DDM) and Free-Cash-Flow-to-Equity Model
(FCFE)   383
Preferred Stock Valuation   386
The Gordon Growth Model   389
Multistage Dividend Discount Models   394
Multipler Models and Relationship Among Price Multiples, Present Value
Models, and Fundamentals   398
Relationships among Price Multiples, Present Value Models, and
Fundamentals   399
Method of Comparables and Valuation Based on Price Multiples   402
Illustration of a Valuation Based on Price Multiples   405
Enterprise Value   407
Asset-Based Valuation   410
Summary   414
References   416
Practice Problems   417
Solutions   424

Fixed Income

Learning Module 1 Fixed-Income Securities: Defining Elements   431

Introduction and Overview of a Fixed-Income Security   431
Overview of a Fixed-Income Security   432
Bond Indenture   438
Bond Indenture   439
Legal, Regulatory, and Tax Considerations   447
Tax Considerations   450

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 © CFA Institute. For candidate use only. Not for distribution.
Contents ix

Principal Repayment Structures   452

Principal Repayment Structures   452
Coupon Payment Structures   456
Floating-Rate Notes   457
Step-Up Coupon Bonds   457
Credit-Linked Coupon Bonds   458
Payment-in-Kind Coupon Bonds   458
Deferred Coupon Bonds   459
Index-Linked Bonds   459
Callable and Putable Bonds   463
Callable Bonds   463
Putable Bonds   465
Convertible Bonds   466
Summary   469
Practice Problems   473
Solutions   478

Learning Module 2 Fixed-Income Markets: Issuance, Trading, and Funding   483

Introduction   483
Classification of Fixed-Income Markets   484
Classification of Fixed-Income Markets   484
Fixed-Income Indexes   491
Investors in Fixed-Income Securities   492
Primary Bond Markets   493
Primary Bond Markets   494
Secondary Bond Markets   499
Sovereign Bonds   501
Characteristics of Sovereign Bonds   502
Credit Quality of Sovereign Bonds   502
Types of Sovereign Bonds   503
Non-Sovereign, Quasi-Government, and Supranational Bonds   505
Non-Sovereign Bonds   505
Quasi-Government Bonds   506
Supranational Bonds   506
Corporate Debt: Bank Loans, Syndicated Loans, and Commercial Paper   507
Bank Loans and Syndicated Loans   508
Commercial Paper   509
Corporate Debt: Notes and Bonds   511
Maturities   511
Coupon Payment Structures   512
Principal Repayment Structures   512
Asset or Collateral Backing   513
Contingency Provisions   513
Issuance, Trading, and Settlement   514
Structured Financial Instruments   516
Capital Protected Instruments   516
Yield Enhancement Instruments   517
Participation Instruments   517
Leveraged Instruments   517

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x Contents

Short-Term Bank Funding Alternatives   519

Retail Deposits   519
Short-Term Wholesale Funds   519
Repurchase and Reverse Repurchase Agreements   521
Structure of Repurchase and Reverse Repurchase Agreements   521
Credit Risk Associated with Repurchase Agreements   523
Summary   525
Practice Problems   528
Solutions   533

Learning Module 3 Introduction to Fixed-Income Valuation   537

Introduction    537
Bond Prices and the Time Value of Money   538
Bond Pricing with a Market Discount Rate   538
Yield-to-Maturity   542
Relationships between the Bond Price and Bond Characteristics   543
Pricing Bonds Using Spot Rates   547
Prices and Yields: Conventions For Quotes and Calculations   549
Flat Price, Accrued Interest, and the Full Price   549
Matrix Pricing   553
Annual Yields for Varying Compounding Periods in the Year   556
Yield Measures for Fixed-Rate Bonds   559
Yield Measures for Floating-Rate Notes   561
Yield Measures for Money Market Instruments   565
The Maturity Structure of Interest Rates   569
Yield Spreads   577
Yield Spreads over Benchmark Rates   577
Yield Spreads over the Benchmark Yield Curve   579
Summary   582
Practice Problems   585
Solutions   595

Learning Module 4 Introduction to Asset-Backed Securities   609

Introduction: Benefits of Securitization   609
Benefits of Securitization for Economies and Financial Markets   610
How Securitization Works   611
An Example of a Securitization   612
Parties to a Securitization and Their Roles   613
Structure of a Securitization   615
Key Role of the Special Purpose Entity   617
Residential Mortgage Loans   620
Maturity   621
Interest Rate Determination   621
Amortization Schedule   622
Prepayment Options and Prepayment Penalties   622
Rights of the Lender in a Foreclosure   623
Mortgage Pass-Through Securities   625
Mortgage Pass-Through Securities   626
Collateralized Mortgage Obligations and Non-Agency RMBS   632

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Contents xi

Sequential-Pay CMO Structures   633

CMO Structures Including Planned Amortization Class and Support
Tranches   635
Other CMO Structures   637
Non-Agency Residential Mortgage-Backed Securities   639
Commercial Mortgage-Backed Securities   640
Credit Risk   640
CMBS Structure   640
Non-Mortgage Asset-Backed Securities   644
Auto Loan ABS   645
Credit Card Receivable ABS   647
Collateralized Debt Obligations   649
CDO Structure   649
An Example of a CDO Transaction   650
Covered Bonds   652
Summary   653
Practice Problems   657
Solutions   664

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© CFA Institute. For candidate use only. Not for distribution.
 © CFA Institute. For candidate use only. Not for distribution.
xiii

How to Use the CFA

Program Curriculum
The CFA® Program exams measure your mastery of the core knowledge, skills, and
abilities required to succeed as an investment professional. These core competencies
are the basis for the Candidate Body of Knowledge (CBOK™). The CBOK consists of
four components:
■ A broad outline that lists the major CFA Program topic areas (www.
cfainstitute.org/programs/cfa/curriculum/cbok)
■ Topic area weights that indicate the relative exam weightings of the top-level
topic areas (www.cfainstitute.org/programs/cfa/curriculum)
■ Learning outcome statements (LOS) that advise candidates about the spe-
cific knowledge, skills, and abilities they should acquire from curriculum
content covering a topic area: LOS are provided in candidate study ses-
sions and at the beginning of each block of related content and the specific
lesson that covers them. We encourage you to review the information about
the LOS on our website (www.cfainstitute.org/programs/cfa/curriculum/
study-sessions), including the descriptions of LOS “command words” on the
candidate resources page at www.cfainstitute.org.
■ The CFA Program curriculum that candidates receive upon exam
registration
Therefore, the key to your success on the CFA exams is studying and understanding
the CBOK. You can learn more about the CBOK on our website: www.cfainstitute.
org/programs/cfa/curriculum/cbok.
The entire curriculum, including the practice questions, is the basis for all exam
questions and is selected or developed specifically to teach the knowledge, skills, and
abilities reflected in the CBOK.

ERRATA
The curriculum development process is rigorous and includes multiple rounds of
reviews by content experts. Despite our efforts to produce a curriculum that is free
of errors, there are instances where we must make corrections. Curriculum errata are
periodically updated and posted by exam level and test date online on the Curriculum
Errata webpage (www.cfainstitute.org/en/programs/submit-errata). If you believe you
have found an error in the curriculum, you can submit your concerns through our
curriculum errata reporting process found at the bottom of the Curriculum Errata
webpage.

DESIGNING YOUR PERSONAL STUDY PROGRAM

An orderly, systematic approach to exam preparation is critical. You should dedicate
a consistent block of time every week to reading and studying. Review the LOS both
before and after you study curriculum content to ensure that you have mastered the
 © CFA Institute. For candidate use only. Not for distribution.
xiv How to Use the CFA Program Curriculum

applicable content and can demonstrate the knowledge, skills, and abilities described
by the LOS and the assigned reading. Use the LOS self-check to track your progress
and highlight areas of weakness for later review.
Successful candidates report an average of more than 300 hours preparing for each
exam. Your preparation time will vary based on your prior education and experience,
and you will likely spend more time on some study sessions than on others.

CFA INSTITUTE LEARNING ECOSYSTEM (LES)

Your exam registration fee includes access to the CFA Program Learning Ecosystem
(LES). This digital learning platform provides access, even offline, to all of the curricu-
lum content and practice questions and is organized as a series of short online lessons
with associated practice questions. This tool is your one-stop location for all study
materials, including practice questions and mock exams, and the primary method by
which CFA Institute delivers your curriculum experience. The LES offers candidates
additional practice questions to test their knowledge, and some questions in the LES
provide a unique interactive experience.

FEEDBACK
Please send any comments or feedback to [email protected], and we will review
your suggestions carefully.
© CFA Institute. For candidate use only. Not for distribution.

Corporate Issuers
© CFA Institute. For candidate use only. Not for distribution.
 © CFA Institute. For candidate use only. Not for distribution.

LEARNING MODULE

1
Cost of Capital-Foundational Topics
by Yves Courtois, CMT, MRICS, CFA, Gene C. Lai, PhD, and Pamela
Peterson Drake, PhD, CFA.
Yves Courtois, CMT, MRICS, CFA, is at KPMG (Luxembourg). Gene C. Lai, PhD, is at the
University of North Carolina at Charlotte (USA). Pamela Peterson Drake, PhD, CFA, is at
James Madison University (USA).

LEARNING OUTCOME
Mastery The candidate should be able to:

calculate and interpret the weighted average cost of capital (WACC)

of a company
describe how taxes affect the cost of capital from different capital
sources
calculate and interpret the cost of debt capital using the
yield-to-maturity approach and the debt-rating approach
calculate and interpret the cost of noncallable, nonconvertible
preferred stock
calculate and interpret the cost of equity capital using the capital
asset pricing model approach and the bond yield plus risk premium
approach
explain and demonstrate beta estimation for public companies,
thinly traded public companies, and nonpublic companies
explain and demonstrate the correct treatment of flotation costs

INTRODUCTION
A company grows by making investments that are expected to increase revenues
1
and profits. It acquires the capital or funds necessary to make such investments by
borrowing (i.e., using debt financing) or by using funds from the owners (i.e., equity
financing). By applying this capital to investments with long-term benefits, the com-
pany is producing value today. How much value? The answer depends not only on the
investments’ expected future cash flows but also on the cost of the funds. Borrowing
is not costless, nor is using owners’ funds.
 © CFA Institute. For candidate use only. Not for distribution.
4 Learning Module 1 Cost of Capital-Foundational Topics

The cost of this capital is an important ingredient in both investment decision

making by the company’s management and the valuation of the company by investors.
If a company invests in projects that produce a return in excess of the cost of capital,
the company has created value; in contrast, if the company invests in projects whose
returns are less than the cost of capital, the company has destroyed value. Therefore,
the estimation of the cost of capital is a central issue in corporate financial manage-
ment and for an analyst seeking to evaluate a company’s investment program and its
competitive position.
Cost of capital estimation is a challenging task. As we have already implied, the cost
of capital is not observable but, rather, must be estimated. Arriving at a cost of capital
estimate requires a multitude of assumptions and estimates. Another challenge is that
the cost of capital that is appropriately applied to a specific investment depends on the
characteristics of that investment: The riskier the investment’s cash flows, the greater
its cost of capital. In reality, a company must estimate project-specific costs of capital.
What is often done, however, is to estimate the cost of capital for the company as a
whole and then adjust this overall corporate cost of capital upward or downward to
reflect the risk of the contemplated project relative to the company’s average project.
This reading is organized as follows: In Section 2, we introduce the cost of capital
and its basic computation. Section 3 presents a selection of methods for estimating
the costs of the various sources of capital: debt, preferred stock, and common equity.
For the latter, two approaches for estimating the equity risk premium are mentioned.
Section 4 discusses beta estimation, a key input in using the CAPM to calculate the
cost of equity, and Section 5 examines the correct treatment of flotation, or capital
issuance, costs. Section 6 highlights methods used by corporations, and a summary
concludes the reading.

2 COST OF CAPITAL

calculate and interpret the weighted average cost of capital (WACC)

of a company
describe how taxes affect the cost of capital from different capital
sources

The cost of capital is the rate of return that the suppliers of capital—lenders and
owners—require as compensation for their contribution of capital. Another way of
looking at the cost of capital is that it is the opportunity cost of funds for the suppliers
of capital: A potential supplier of capital will not voluntarily invest in a company unless
its return meets or exceeds what the supplier could earn elsewhere in an investment of
comparable risk. In other words, to raise new capital, the issuer must price the security
to offer a level of expected return that is competitive with the expected returns being
offered by similarly risky securities.
A company typically has several alternatives for raising capital, including issuing
equity, debt, and hybrid instruments that share characteristics of both debt and equity,
such as preferred stock and convertible debt. Each source selected becomes a com-
ponent of the company’s funding and has a cost (required rate of return) that may be
called a component cost of capital. Because we are using the cost of capital in the
evaluation of investment opportunities, we are dealing with a marginal cost—what it
would cost to raise additional funds for the potential investment project. Therefore,
 © CFA Institute. For candidate use only. Not for distribution.
Cost of Capital 5

the cost of capital that the investment analyst is concerned with is a marginal cost,
and the required return on a security is the issuer’s marginal cost for raising additional
capital of the same type.
The cost of capital of a company is the required rate of return that investors demand
for the average-risk investment of a company. A company with higher-than-average-risk
investments must pay investors a higher rate of return, competitive with other securi-
ties of similar risk, which corresponds to a higher cost of capital. Similarly, a company
with lower-than-average-risk investments will have lower rates of return demanded
by investors, resulting in a lower associated cost of capital. The most common way
to estimate this required rate of return is to calculate the marginal cost of each of the
various sources of capital and then calculate a weighted average of these costs. You
will notice that the debt and equity costs of capital and the tax rate are all understood
to be “marginal” rates: the cost or tax rate for additional capital.
The weighted average is referred to as the weighted average cost of capital
(WACC). The WACC is also referred to as the marginal cost of capital (MCC) because
it is the cost that a company incurs for additional capital. Further, this is the current
cost: what it would cost the company today.
The weights are the proportions of the various sources of capital that the company
uses to support its investment program. It is important to note that the weights should
represent the company’s target capital structure, not the current capital structure.
A company’s target capital structure is its chosen (or targeted) proportions of debt
and equity, whereas its current capital structure is the company’s actual weighting
of debt and equity. For example, suppose the current capital structure is one-third
debt, one-third preferred stock, and one-third common stock. Now suppose the new
investment will be financed by issuing more debt so that capital structure changes to
one-half debt, one-fourth preferred stock, and one-fourth common stock. Those new
weights (i.e., the target weights) should be used to calculate the WACC.
Taking the sources of capital to be common stock, preferred stock, and debt and
allowing for the fact that in some jurisdictions, interest expense may be tax deductible,
the expression for WACC is
WACC = wdrd(1 – t) + wprp + were,   (1)
where

wd = the target proportion of debt in the capital structure when the company
raises new funds
rd = the before-tax marginal cost of debt

t = the company’s marginal tax rate

wp = the target proportion of preferred stock in the capital structure when the
company raises new funds

rp = the marginal cost of preferred stock

we = the target proportion of common stock in the capital structure when the
company raises new funds

re = the marginal cost of common stock

Note that preferred stock is also referred to as preferred equity, and common stock
is also referred to as common equity, or equity.
 © CFA Institute. For candidate use only. Not for distribution.
6 Learning Module 1 Cost of Capital-Foundational Topics

EXAMPLE 1

Computing the Weighted Average Cost of Capital

1. Assume that ABC Corporation has the following capital structure: 30% debt,
10% preferred stock, and 60% common stock, or equity. Also assume that
interest expense is tax deductible. ABC Corporation wishes to maintain
these proportions as it raises new funds. Its before-tax cost of debt is 8%, its
cost of preferred stock is 10%, and its cost of equity is 15%. If the company’s
marginal tax rate is 40%, what is ABC’s weighted average cost of capital?

Solution:
The weighted average cost of capital is
WACC = (0.3)(0.08)(1 – 0.40) + (0.1)(0.1) + (0.6)(0.15)

= 11.44%.
The cost for ABC Corporation to raise new funds while keeping its current
capital structure is 11.44%.

Self reflection:
Maintaining its current capital structure, what happens to ABC’s weighted
average cost of capital if component costs increase or decrease? What hap-
pens if the company’s marginal tax rate increases or decreases?

There are important points concerning the calculation of the WACC as shown
in Equation 1 that the analyst must be familiar with. The next section addresses the
key issue of taxes.

Taxes and the Cost of Capital

The marginal cost of debt financing is the cost of debt after considering the allow-
able deduction for interest on debt based on the country’s tax law. If interest cannot
be deducted for tax purposes, the tax rate applied is zero, so the effective marginal
cost of debt is equal to rd in Equation 1. If interest can be deducted in full, the tax
deductibility of debt reduces the effective marginal cost of debt to reflect the income
shielded from taxation (often referred to as the tax shield) and the marginal cost of
debt is rd(1 – t). For example, suppose a company pays €1 million in interest on its €10
million of debt. The cost of this debt is not €1 million, because this interest expense
reduces taxable income by €1 million, resulting in a lower tax. If the company has a
marginal tax rate of 40%, this €1 million of interest costs the company (€1 million)
(1 − 0.4) = €0.6 million because the interest reduces the company’s tax bill by €0.4
million. In this case, the before-tax cost of debt is 10%, whereas the after-tax cost of
debt is (€0.6 million)/(€10 million) = 6%, which can also be calculated as 10%(1 – 0.4).
In jurisdictions in which a tax deduction for a business’s interest expense is allowed,
there may be reasons why additional interest expense is not tax deductible (e.g., not
having sufficient income to offset with interest expense). If the above company with
€10 million in debt were in that position, its effective marginal cost of debt would be
10% rather than 6% because any additional interest expense would not be deductible for
tax purposes. In other words, if the limit on tax deductibility is reached, the marginal
cost of debt is the cost of debt without any adjustment for a tax shield.
 © CFA Institute. For candidate use only. Not for distribution.
Costs of the Various Sources of Capital 7

EXAMPLE 2

Incorporating the Effect of Taxes on the Costs of Capital

Jorge Ricard, a financial analyst, is estimating the costs of capital for the Zeale
Corporation. In the process of this estimation, Ricard has estimated the before-tax
costs of capital for Zeale’s debt and equity as 4% and 6%, respectively. What are
the after-tax costs of debt and equity if there is no limit to the tax deductibility
of interest and Zeale’s marginal tax rate is:

1. 30%?
2. 48%?
​

Marginal Tax Rate After-Tax Cost of Debt After-Tax Cost of Equity

Solution to 1: 30% 0.04(1 − 0.30) = 2.80%. 6%

Solution to 2: 48% 0.04(1 − 0.48) = 2.08%. 6%
​

Note: There is no adjustment for taxes in the case of equity; the before-tax cost
of equity is equal to the after-tax cost of equity.

COSTS OF THE VARIOUS SOURCES OF CAPITAL

3
calculate and interpret the cost of debt capital using the
yield-to-maturity approach and the debt-rating approach
calculate and interpret the cost of noncallable, nonconvertible
preferred stock
calculate and interpret the cost of equity capital using the capital
asset pricing model approach and the bond yield plus risk premium
approach

Each source of capital has a different cost because of the differences among the sources,
such as risk, seniority, contractual commitments, and potential value as a tax shield.
We focus on the costs of three primary sources of capital: debt, preferred stock, and
common equity.

Cost of Debt
The cost of debt is the cost of debt financing to a company when it issues a bond or
takes out a bank loan. That cost is equal to the risk-free rate plus a premium for risk.
A company that is perceived to be very risky would have a higher cost of debt than one
that presents little investment risk. Factors that might affect the level of investment
risk include profitability, stability of profits, and the degree of financial leverage. In
general, the cost of debt would be higher for companies that are unprofitable, whose
profits are not stable, or that are already using a lot of debt in their capital structure. We
discuss two methods to estimate the before-tax cost of debt, rd: the yield-to-maturity
approach and debt-rating approach.
 © CFA Institute. For candidate use only. Not for distribution.
8 Learning Module 1 Cost of Capital-Foundational Topics

Yield-to-Maturity Approach
The before-tax required return on debt is typically estimated using the expected yield
to maturity (YTM) of the company’s debt based on current market values. YTM is
the annual return that an investor earns on a bond if the investor purchases the bond
today and holds it until maturity. In other words, it is the yield, rd, that equates the
present value of the bond’s promised payments to its market price:

[t=1​(​1 + _
​2 ​)​​]
PM ​T1​ ​ PM ​Tn​ ​ n PM ​Tt​​
​​P0​ ​ = _ _ _ _ ​​+ _
FV FV
​ ​r​d​ ​+ … + ​ r​d​ n ​+ ​ r​d​ n ​ = ​​ ​∑ ​ ​r​ ​ t ​
​ ​r​d​ n ,​​ (2)
​(​1 + ​2 ​)​
_ ​_ ​_
​(​1 + ​2 ​)​ ​ ​(​1 + ​2 ​)​ ​ d _
​(​1 + ​2 ​)​ ​

where

P0 = the current market price of the bond

PMTt = the interest payment in period t

rd = the yield to maturity

n = the number of periods remaining to maturity

FV = the maturity value of the bond

In this valuation equation, the constant 2 reflects the assumption that the bond pays
interest semi-annually (which is the case in many but not all countries) and that any
intermediate cash flows (i.e., the interest payments prior to maturity) are reinvested
at the rate rd/2 semi-annually.
Example 3 illustrates the calculation of the after-tax cost of debt.

EXAMPLE 3

Calculating the After-Tax Cost of Debt

1. Valence Industries issues a bond to finance a new project. It offers a 10-year,

$1,000 face value, 5% semi-annual coupon bond. Upon issue, the bond sells
at $1,025. What is Valence’s before-tax cost of debt? If Valence’s marginal
tax rate is 35%, what is Valence’s after-tax cost of debt?

Solution:
The following are given:
PV = $1, 025.
FV = $1, 000.
PMT = 5 % of 1, 000 ÷ 2 = $25.
​​
  
   
   ​ ​ ​​
n = 10 × 2 = 20.
$1, 025 = ​[
t=1 ​ ​1 + i​ ​​]
20 $1, 000
​( $25) t ​ ​​+ _
​ ​∑ _ ​( ​.
​ ​1 + i​)​20​

Before proceeding to solve the problem, we already know that the before-tax
cost of debt must be less than 5% because the present value of the bond is
greater than the face value. We can use a financial calculator to solve for
i, the six-month yield. Because i = 2.342%, the before-tax cost of debt is rd
= 2.342% × 2 = 4.684%, and Valence’s after-tax cost of debt is rd(1 − t) =
0.04684(1 − 0.35) = 0.03045, or 3.045%.
 © CFA Institute. For candidate use only. Not for distribution.
Costs of the Various Sources of Capital 9

Debt-Rating Approach
When a reliable current market price for a company’s debt is not available, the
debt-rating approach can be used to estimate the before-tax cost of debt. Based on
a company’s debt rating, we estimate the before-tax cost of debt by using the yield
on comparably rated bonds for maturities that closely match that of the company’s
existing debt.
Suppose a company’s capital structure includes debt with an average maturity of
10 years and the company’s marginal tax rate is 35%. If the company’s rating is AAA
and the yield on debt with the same debt rating and similar maturity is 4%, the com-
pany’s after-tax cost of debt is
rd(1 – t) = 0.04(1 – 0.35) = 2.6%.

EXAMPLE 4

Calculating the After-Tax Cost of Debt

1. Elttaz Company’s capital structure includes debt with an average maturity of

15 years. The company’s rating is A1, and it has a marginal tax rate of 18%. If
the yield on comparably rated A1 bonds with similar maturity is 6.1%, what
is Elttaz’s after-tax cost of debt?

Solution:
Elttaz’s after-tax cost of debt is
rd(1 – t) = 0.061(1 – 0.18) = 5.0%.

A consideration when using this approach is that debt ratings are ratings of the
debt issue itself, with the issuer being only one of the considerations. Other factors,
such as debt seniority and security, also affect ratings and yields, so care must be
taken to consider the likely type of debt to be issued by the company in determining
the comparable debt rating and yield. The debt-rating approach is a simple example
of pricing on the basis of valuation-relevant characteristics, which in bond markets
has been known as evaluated pricing or matrix pricing.

Issues in Estimating the Cost of Debt

There are other issues to consider when estimating the cost of debt. Among these
are whether the debt is fixed rate or floating rate, whether it has option-like features,
whether it is unrated, and whether the company uses leases instead of typical debt.

Fixed-Rate Debt vs. Floating-Rate Debt

Up to now, we have assumed that the interest on debt is a fixed amount each period.
We can observe market yields of the company’s existing debt or market yields of debt
of similar risk in estimating the before-tax cost of debt. However, the company may
also issue floating-rate debt, in which the interest rate adjusts periodically according
to a prescribed index, such as the prime rate, over the life of the instrument.
Estimating the cost of a floating-rate security is difficult because the cost of this
form of capital over the long term depends not only on the current yields but also on
the future yields. The analyst may use the current term structure of interest rates and
term structure theory to assign an average cost to such instruments.
 © CFA Institute. For candidate use only. Not for distribution.
10 Learning Module 1 Cost of Capital-Foundational Topics

Debt with Optionlike Features

How should an analyst determine the cost of debt when the company uses debt with
option-like features, such as call, conversion, or put provisions? Clearly, options affect
the value of debt. For example, a callable bond would have a yield greater than a similar
noncallable bond of the same issuer because bondholders want to be compensated
for the call risk associated with the bond. In a similar manner, the put feature of a
bond, which provides the investor with an option to sell the bond back to the issuer
at a predetermined price, has the effect of lowering the yield on a bond below that
of a similar nonputable bond. Likewise, convertible bonds, which give investors the
option of converting the bonds into common stock, lower the yield on the bonds
below that of similar nonconvertible bonds.
If the company already has debt outstanding incorporating optionlike features that
the analyst believes are representative of the future debt issuance of the company, the
analyst may simply use the yield to maturity on such debt in estimating the cost of debt.
If the analyst believes that the company will add or remove option features in future
debt issuance, the analyst can make market value adjustments to the current YTM to
reflect the value of such additions or deletions. The technology for such adjustments
is an advanced topic that is outside the scope of this coverage.

Nonrated Debt
If a company does not have any debt outstanding or if the yields on the company’s
existing debt are not available, the analyst may not always be able to use the yield on
similarly rated debt securities. It may be the case that the company does not have rated
bonds. Although researchers offer approaches for estimating a company’s “synthetic”
debt rating based on financial ratios, these methods are imprecise because debt ratings
incorporate not only financial ratios but also information about the particular bond
issue and the issuer that are not captured in financial ratios. A further discussion of
these methods is outside the scope of this reading.

Leases
A lease is a contractual obligation that can substitute for other forms of borrowing.
This is true whether the lease is an operating lease or a finance lease (also called
a capital lease). If the company uses leasing as a source of capital, the cost of these
leases should be included in the cost of capital. The cost of this form of borrowing is
similar to that of the company’s other long-term borrowing.

Cost of Preferred Stock

The cost of preferred stock is the cost that a company has committed to pay pre-
ferred stockholders as a preferred dividend when it issues preferred stock. In the case
of nonconvertible, noncallable preferred stock that has a fixed dividend rate and no
maturity date (fixed-rate perpetual preferred stock), we can use the formula for
the value of a preferred stock:
​Dp​ ​
​​Pp​ ​ = _
​​rp​ ​​,​

where

Pp = the current preferred stock price per share

Dp = the preferred stock dividend per share

rp = the cost of preferred stock

We can rearrange this equation to solve for the cost of preferred stock:
 © CFA Institute. For candidate use only. Not for distribution.
Costs of the Various Sources of Capital 11

​Dp​ ​
​​rp​ ​ = _
​​P​ ​​.​ (3)
p

Therefore, the cost of preferred stock is the preferred stock’s dividend per share
divided by the current preferred stock’s price per share. Unlike interest on debt, the
dividend on preferred stock is not tax-deductible by the company; therefore, there is
no adjustment to the cost for taxes.
A preferred stock may have a number of features that affect its yield and hence
its cost. These features include a call option, cumulative dividends, participating
dividends, adjustable-rate dividends, and convertibility into common stock. When
estimating a yield based on current yields of the company’s preferred stock, we must
make appropriate adjustments for the effects of these features on the yield of an issue.
For example, if the company has callable, convertible preferred stock outstanding yet
it is expected that the company will issue only noncallable, nonconvertible preferred
stock in the future, we would have to either use the current yields on comparable
companies’ noncallable, nonconvertible preferred stock or estimate the yield on pre-
ferred equity using methods outside the scope of this coverage.

EXAMPLE 5

Calculating the Cost of Preferred Stock

1. Consider a company that has one issue of preferred stock outstanding with
a $3.75 cumulative dividend. If the price of this stock is $80, what is the
estimate of its cost of preferred stock?

Solution:
Cost of preferred stock = $3.75/$80 = 4.6875%.

EXAMPLE 6

Choosing the Best Estimate of the Cost of Preferred Stock

1. Wim Vanistendael is finance director of De Gouden Tulip N.V., a leading

Dutch flower producer and distributor. He has been asked by the CEO to
calculate the cost of preferred stock and has recently obtained the following
information:

■ The issue price of preferred stock was €3.5 million, and the preferred
dividend is 5%.
■ If the company issued new preferred stock today, the preferred divi-
dend yield would be 6.5%.
■ The company’s marginal tax rate is 30.5%.

What is the cost of preferred stock for De Gouden Tulip N.V.?

Solution:
If De Gouden Tulip were to issue new preferred stock today, the divi-
dend yield would be close to 6.5%. The current terms thus prevail over the
past terms when evaluating the actual cost of preferred stock. The cost of
preferred stock for De Gouden Tulip is, therefore, 6.5%. Because preferred
 © CFA Institute. For candidate use only. Not for distribution.
12 Learning Module 1 Cost of Capital-Foundational Topics

dividends offer no tax shield, there is no adjustment made on the basis of

the marginal tax rate.

Cost of Common Equity

The cost of common equity, re, usually referred to simply as the cost of equity, is the
rate of return required by a company’s common stockholders. A company may increase
common equity through the reinvestment of earnings—that is, retained earnings—or
through the issuance of new shares of stock.
The estimation of the cost of equity is challenging because of the uncertain
nature of the future cash flows in terms of the amount and timing. Commonly used
approaches for estimating the cost of equity include the capital asset pricing model
(CAPM) method and the bond yield plus risk premium (BYPRP) method. In practice,
analysts may use more than one approach to develop the cost of equity. A survey of
analysts showed that the CAPM approach is used by 68% of respondents, whereas a
build-up approach (bond yield plus a premium) is used by 43% of respondents (Pinto,
Robinson, and Stowe 2019).

Capital Asset Pricing Model Approach

In the CAPM approach, we use the basic relationship from the capital asset pricing
model theory that the expected return on a stock, E(Ri), is the sum of the risk-free
rate of interest, RF, and a premium for bearing the stock’s market risk, βi(R M − RF).
Note that this premium incorporates the stock’s return sensitivity to changes in the
market return, or market-related risk, known as βi, or beta:
​E​(​ ​Ri​​)​​ = R
​ F​ ​+ β​ i​​​[​E​(​ ​RM
​ ​)​​− ​RF​ ​]​​,​ (4)
where

βi = the return sensitivity of stock i to changes in the market return

E(RM) = the expected return on the market

E(RM) − RF = the expected market risk premium

A risk-free asset is defined here as an asset that has no default risk. A common
proxy for the risk-free rate is the yield on a default-free government debt instrument.
In general, the selection of the appropriate risk-free rate should be guided by the
duration of projected cash flows. For example, for the evaluation of a project with an
estimated useful life of 10 years, the rate on the 10-year Treasury bond would be an
appropriate proxy to use.

Using the CAPM to Estimate the Cost of Equity

1. Valence Industries wants to know its cost of equity. Its chief financial officer
(CFO) believes the risk-free rate is 5%, the market risk premium is 7%, and
Valence’s equity beta is 1.5. What is Valence’s cost of equity using the CAPM
approach?

Solution:
The cost of equity for Valence is 5% + 1.5(7%) = 15.5%.
 © CFA Institute. For candidate use only. Not for distribution.
Costs of the Various Sources of Capital 13

2. Exxon Mobil Corporation, BP p.l.c., and Total S.A. are three “super major”
integrated oil and gas companies headquartered, respectively, in the Unit-
ed States, the United Kingdom, and France. An analyst estimates that the
market risk premium in the United States, the United Kingdom, and the
eurozone are, respectively, 4.4%, 5.5%, and 5.9%. Other information is sum-
marized in Exhibit 1.
​

Exhibit 1: ExxonMobil, BP, and Total

​

Estimated Market
Company Beta Risk Premium (%) Risk-Free Rate (%)

Exxon Mobil 0.90 4.4 2.8

Corporation
BP p.l.c. 0.78 5.5 2.0
Total S.A. 0.71 5.9 1.7
​

Source: Bloomberg; Fernandez, Pershn, and Acin (2018) survey.

Using the capital asset pricing model, calculate the cost of equity for:

1. Exxon Mobil Corporation.

2. BP p.l.c.
3. Total S.A.
Solution:
1. The cost of equity for ExxonMobil is 2.8% + 0.90(4.4%) = 6.76%.
2. The cost of equity for BP is 2.0% + 0.78(5.5%) = 6.29%.
3. The cost of equity for Total is 1.7% + 0.71(5.9%) = 5.89%.

The expected market risk premium, or E(RM − RF), is the premium that investors
demand for investing in a market portfolio relative to the risk-free rate. When using
the CAPM to estimate the cost of equity, in practice we typically estimate beta relative
to an equity market index. In that case, the market premium estimate we are using is
actually an estimate of the equity risk premium (ERP). Therefore, we are using the
terms market risk premium and equity risk premium interchangeably.
An alternative to the CAPM to accommodate risks that may not be captured by
the market portfolio alone is a multifactor model that incorporates factors that may
be other sources of priced risk (risk for which investors demand compensation for
bearing), including macroeconomic factors and company-specific factors. In general,
E​(​ ​Ri​​)​​ = R ​ ​(​ ​Factor risk premium​)​1​
​ F​ ​+ β​ i1
+ ​​ ​βi2
   
     ​ ​(​ ​Factor risk premium​)​2​+ …​ ​​ ​ (5)
+ ​βij​ ​(​ ​Factor risk premium​)​j​,

where

βij = stock i’s sensitivity to changes in the jth factor

(Factor risk premium)j = expected risk premium for the jth factor
The basic idea behind these multifactor models is that the CAPM beta may not capture
all the risks, especially in a global context, which include inflation, business-cycle,
interest rate, exchange rate, and default risks.
 © CFA Institute. For candidate use only. Not for distribution.
14 Learning Module 1 Cost of Capital-Foundational Topics

There are several ways to estimate the equity risk premium, although there is no
general agreement as to the best approach. The two we discuss are the historical equity
risk premium approach and the survey approach.
The historical equity risk premium approach is a well-established approach
based on the assumption that the realized equity risk premium observed over a long
period of time is a good indicator of the expected equity risk premium. This approach
requires compiling historical data to find the average rate of return of a country’s mar-
ket portfolio and the average rate of return for the risk-free rate in that country. For
example, an analyst might use the historical returns to the TOPIX Index to estimate
the risk premium for Japanese equities. The exceptional bull market observed during
the second half of the 1990s and the bursting of the technology bubble that followed
during 2000–2002 remind us that the time period for such estimates should cover
complete market cycles.
Elroy Dimson, Paul Marsh, and Mike Staunton (2018) conducted an analysis of
the equity risk premiums observed in markets located in 21 countries, including the
United States, over the period 1900–2017. These researchers found that the annual-
ized US equity risk premium relative to US Treasury bills was 5.6% (geometric mean)
and 7.5% (arithmetic mean). They also found that the annualized US equity risk
premium relative to bonds was 4.4% (geometric mean) and 6.5% (arithmetic mean).
Jeremy Siegel (2005), covering the period from 1802 through 2004, observed an equity
return of 6.82% and an equity risk premium in the range of 3.31%–5.36%. Note that
the arithmetic mean is greater than the geometric mean as a result of the significant
volatility of the observed market rate of return and the observed risk-free rate. Under
the assumption of an unchanging distribution of returns over time, the arithmetic
mean is the unbiased estimate of the expected single-period equity risk premium, but
the geometric mean better reflects the growth rate over multiple periods. In Exhibit 2,
we provide historical estimates of the equity risk premium for a few of the developed
markets from Dimson et al. (2018).

Exhibit 2: Selected Equity Risk Premiums Relative to Bonds

(1900–2017)

Mean

Geometric Arithmetic

Australia 5.0% 6.6%

Canada 3.5 5.1
France 3.1 5.4
Germany 5.1 8.4
Japan 5.1 9.1
South Africa 5.3 7.1
Switzerland 2.2 3.7
United Kingdom 3.7 5.0
United States 4.4 6.5

Note: Germany excludes 1922–1923.

Source: Dimson, Marsh, and Staunton (2018).
 © CFA Institute. For candidate use only. Not for distribution.
Costs of the Various Sources of Capital 15

To illustrate the historical method as applied in the CAPM, suppose that we use the
historical geometric mean for US equity of 4.4% to value Apple Computer as of early
August 2018. According to Yahoo Finance, Apple had a beta of 1.14 at that time. Using
a 10-year US Treasury bond yield of 3.0% to represent the risk-free rate, the estimate
of the cost of equity for Apple Computer is 3.0% + 1.14(4.4%) = 8.02%.
In general, the equity risk premium can be written as
_ _
​ERP = ​R ​M​− ​R ​F,​
_ _
where ERP is the equity risk premium, ​R ​M​is the mean return for equity, and ​R ​F​​
the risk-free rate.
The historical premium approach has several limitations. One limitation is that the
level of risk of the stock index may change over time. Another is that the risk aversion
of investors may change over time. A third limitation is that the estimates are sensitive
to the method of estimation and the historical period covered.

EXAMPLE 6

Estimating the Equity Risk Premium Using Historical Rates

of Return

1. Suppose that the arithmetic average T-bond rate observed over the last 90
years is an unbiased estimator for the risk-free rate and is 4.88%. Likewise,
suppose the arithmetic average of return on the market observed over the
last 90 years is an unbiased estimator for the expected return for the market.
The average rate of return of the market was 9.65%. Calculate the equity risk
premium.

Solution:
_ _
​ERP = ​R ​M​− ​R ​F​ = 9.65 %   − 4.88 %   = 4.77 % .​

Another approach to estimate the equity risk premium is quite direct: Ask a
panel of finance experts for their estimates, and take the mean response. This is the
survey approach. For example, a survey of US CFOs in December 2017 found that
the average expected US equity risk premium over the next 10 years was 4.42% and
the median was 3.63% (Graham and Harvey 2018).
Once we have an estimate of the equity risk premium, we fine-tune this estimate
for the particular company or project by adjusting it for the specific systematic risk
of the project. We adjust for the specific systematic risk by multiplying the market
risk premium by beta to arrive at the company’s or project’s risk premium, which we
then add to the risk-free rate to determine the cost of equity within the framework
of the CAPM.

Bond Yield plus Risk Premium Approach

For companies with publicly traded debt, the bond yield plus risk premium approach
provides a quick estimate of the cost of equity. The BYPRP approach is based on the
fundamental tenet in financial theory that the cost of capital of riskier cash flows is
higher than that of less risky cash flows. In this approach, we sum the before-tax cost
of debt, rd, and a risk premium that captures the additional yield on a company’s stock
relative to its bonds. The estimate is, therefore,
re = rd + Risk premium. (6)
 © CFA Institute. For candidate use only. Not for distribution.
16 Learning Module 1 Cost of Capital-Foundational Topics

The risk premium compensates for the additional risk of the equity issue compared
with the debt issue (recognizing that debt has a prior claim on the cash flows of the
company). This risk premium is not to be confused with the equity risk premium.
The equity risk premium is the difference between the cost of equity and the risk-free
rate of interest. The risk premium in the bond yield plus risk premium approach is
the difference between the cost of equity and the cost of debt of the company. Ideally,
this risk premium is forward looking, representing the additional risk associated with
the equity of the company as compared with the company’s debt. However, we often
estimate this premium using historical spreads between bond yields and stock yields.
In developed country markets, a typical risk premium added is in the range of 3%–5%.
Looking again at Apple Computer, as of early August 2018, the yield to maturity
of Apple’s 3.35% coupon bonds maturing in 2027 was approximately 3.56%. Adding
an arbitrary risk premium of 4.0% produces an estimate of the cost of equity of 3.56%
+ 4.0% = 7.56%. This estimate contrasts with the higher estimate of 8.026% from the
CAPM approach. Such disparities are not uncommon and reflect the difficulty of cost
of equity estimation.

4 ESTIMATING BETA

explain and demonstrate beta estimation for public companies,

thinly traded public companies, and nonpublic companies

Beta is an estimate of the company’s systematic or market-related risk. It is a critical

component of the CAPM, and it can be used to calculate a company’s WACC. Therefore,
it is essential to have a good understanding of how beta is estimated.

Estimating Beta for Public Companies

The simplest estimate of beta results from an ordinary least squares regression of the
return on the stock on the return on the market. The result is often called an unad-
justed or “raw” historical beta. The actual values of beta estimates are influenced by
several choices:
■ The choice of the index used to represent the market portfolio: For US equi-
ties, the S&P 500 Index and NYSE Composite have been traditional choices.
In Japan, analysts would likely use the Nikkei 225 Index.
■ The length of the data period and the frequency of observations: The most
common choice is five years of monthly data, yielding 60 observations.
Researchers have observed that beta tends to regress toward 1.0. In other words,
the value of a stock’s beta in a future period is likely to be closer to the mean value of
1.0, the beta of an average-systematic-risk security, than to the value of the calculated
raw beta. Because valuation is forward looking, it is logical to adjust the raw beta so
that it more accurately predicts a future beta. The most commonly used adjustment
was introduced by Blume (1971):
Adjusted beta = (2/3)(Unadjusted beta) + (1/3)(1.0). (7)
For example, if the beta from a regression of an asset’s returns on the market return
is 1.30, adjusted beta is (2/3)(1.30) + (1/3)(1.0) = 1.20. Equation 7 acts to “smooth”
raw betas by adjusting betas above and below 1.0 toward 1.0. Vendors of financial
information, such as Bloomberg, often report both raw and adjusted betas.
 © CFA Institute. For candidate use only. Not for distribution.
Estimating Beta 17

EXAMPLE 7

Estimating the Adjusted Beta for a Public Company

1. Betty Lau is an analyst trying to estimate the cost of equity for Singapore
Telecommunications Limited. She begins by running an ordinary least
squares regression to estimate the beta. Her estimated value is 0.4, which
she believes needs adjustment. What is the adjusted beta value she should
use in her analysis?

Solution:
Adjusted beta = (2/3)(0.4) + (1/3)(1.0) = 0.6.

Arriving at an estimated beta for publicly traded companies is generally not a

problem because of the accessibility of stock return data, the ease of use of estimating
beta using simple regression, and the availability of estimated betas on publicly traded
companies from financial analysis vendors.
The challenge comes in estimating a beta for a company that is thinly traded
or nonpublic or for a project that is not the average or typical project of a publicly
traded company. Estimating beta in these cases requires proxying for the beta by
using information on the project or company combined with the beta of a publicly
traded company.

Estimating Beta for Thinly Traded and Nonpublic Companies

It is not possible to run an ordinary least squares regression to estimate beta if a stock
is thinly traded or a company is nonpublic. When a share issue trades infrequently,
the most recent transaction price may be stale and may not reflect underlying changes
in value. If beta is estimated on the basis of, for example, a monthly data series in
which missing values are filled with the most recent transaction price, the estimated
beta will be too small. This is because this methodology implicitly assumes that the
stock’s price is more stable than it really is. As a result, the required return on equity
will be understated.
In these cases, a practical alternative is to base the beta estimate on the betas of
comparable companies that are publicly traded. A comparable company, also called
a peer company, is a company that has similar business risk. A comparable, or peer,
company can be identified by using an industry classification system, such as the
MSCI/Standard & Poor’s Global Industry Classification Standard (GICS) or the FTSE
Industry Classification Benchmark (ICB). The analyst can then indirectly estimate the
beta on the basis of the betas of the peer companies.
Because financial leverage can affect beta, an adjustment must be made if the peer
company has a substantially different capital structure. First, the peer company’s beta
must be unlevered to estimate the beta of the assets—reflecting only the systematic
risk arising from the fundamentals of the industry. Then, the unlevered beta, often
referred to as the asset beta because it reflects the business risk of the assets, must
be re-levered to reflect the capital structure of the company in question.
Let βE be the equity beta of the peer company before removing the effects of
leverage. Assuming the debt of the peer company is of high quality—so that the debt’s
beta, or βD, is approximately equal to zero (that is, it is assumed to have no market
risk)—analysts can use the following expression to unlever the beta:

[ 1 + (1 − t ) ​E ​]
​ ​ = ​βE​ ​​ _
​​βU ​ 1
D ​ ​​,​
_ (8)
 © CFA Institute. For candidate use only. Not for distribution.
18 Learning Module 1 Cost of Capital-Foundational Topics

where βU is the unlevered beta, t is the marginal tax rate of the peer company, and
D and E are the market values of debt and equity, respectively, of the peer company.
Now we can re-lever the unlevered beta by rearranging the equation to reflect the
capital structure of the thinly traded or nonpublic company in question:
​ ​​[​1 + (1 − t ) _
​​βE​ ​ = β​ U E ​]​​.​
​D (9)

where βE is now the equity beta of the thinly traded or nonpublic company, t is
the marginal tax rate of the thinly traded or nonpublic company, and D and E are
the debt-to-equity values, respectively, of the thinly traded or nonpublic company.

EXAMPLE 8

Estimating the Adjusted Beta for a Nonpublic Company

1. Raffi Azadian wants to determine the cost of equity for Elucida Oncology,
a privately held company. Raffi realizes that he needs to estimate Elucida’s
beta before he can proceed. He determines that Merck & Co. is an appropri-
ate publicly traded peer company. Merck has a beta of 0.7, it is 40% funded
by debt, and its marginal tax rate is 21%. If Elucida is only 10% funded by
debt and its marginal tax rate is also 21%, what is Elucida’s beta?

Solution:

Since Merck is 40% funded by debt, it is 60% funded by equity. Therefore,

[ 1 + (1 − 0.21 ) ​(​ ​0.6 )​ ​​]

​   1
​Unlevered beta = (0.7 ) ​​ _______________
0.4 ​ ​​ = 0.46.​
_

Now we re-lever the unlevered beta using Elucida’s tax rate and capital
structure:

​Elucida's beta = 0.46​[​ ​1 + (1 − 0.21 ) ​( ​0.9 ​)​​]​​ = 0.50.​

0.1
​_

The following table and figure show how Elucida’s beta increases as leverage
rises.
Debt-to-Equity Ratio Equity Beta Equity Beta
0.00 0.46
4.0
0.11 0.50 3.5
0.25 0.55 3.0
0.43 0.62 2.5
0.67 0.70 2.0
1.00 0.82 1.5
1.50 1.01 1.0
2.33 1.31 0.5
4.00 1.91 0
9.00 3.73 0 2 4 6 8 10
Debt-to-Equity Ratio
The beta estimate can then be used to determine the component cost of
equity and combined with the cost of debt in a weighted average to provide
an estimate of the cost of capital for the company.
 © CFA Institute. For candidate use only. Not for distribution.
Estimating Beta 19

EXAMPLE 9

Estimating the Weighted Average Cost of Capital

1. Georg Schrempp is the CFO of Bayern Chemicals KgaA, a German manu-

facturer of industrial, commercial, and consumer chemical products. Bayern
Chemicals is privately owned, and its shares are not listed on an exchange.
The CFO has appointed Markus Meier, CFA, a third-party valuator, to per-
form a stand-alone valuation of Bayern Chemicals. Meier has access to the
following information to calculate Bayern Chemicals’ weighted average cost
of capital:

■ The nominal risk-free rate, represented by the yield on the long-term

10-year German bund, was 4.5% at the valuation date.
■ The average long-term historical equity risk premium in Germany is
assumed to be 5.7%.
■ Bayern Chemicals’ corporate tax rate is 38%.
■ Bayern Chemicals’ target debt-to-equity ratio is 0.7. Its capital struc-
ture is 41% debt.
■ Bayern Chemicals’ cost of debt has an estimated spread of 225 bps
over the 10-year bund.
■ Exhibit 3 supplies additional information on comparables for Bayern
Chemicals.
​

Exhibit 3: Information on Comparables

​

Tax Market Net

Comparable Rate Capitalization Debt in
Companies Country (%) in Millions Millions D/E Beta

British United 30.0 4,500 6,000 1.33 1.45

Chemicals Ltd. Kingdom
Compagnie France 30.3 9,300 8,700 0.94 0.75
Petrochimique
S.A.
Rotterdam Netherlands 30.5 7,000 7,900 1.13 1.05
Chemie N.V.
Average 1.13 1.08
​

Based only on the information given, calculate Bayern Chemicals’ WACC.

Solution:
To calculate the cost of equity, the first step is to “unlever” the betas of the
comparable companies and calculate an average for a company with busi-
ness risk similar to the average of these companies:
​

Comparable Companies Unlevered Beta

​0.75 = ​[​ _______________

1 + (1 − 0.30 ) (1.33) ]
​   1.45 ​ ​​
British Chemicals Ltd.

​0.45 = ​​[________________
1 + (1 − 0.303 ) (0.94) ]
​   0.75 ​ ​​
Compagnie Petrochimique S.A.
 © CFA Institute. For candidate use only. Not for distribution.
20 Learning Module 1 Cost of Capital-Foundational Topics

Comparable Companies Unlevered Beta

​0.59 = ​​[________________
1 + (1 − 0.305 ) (1.13) ]
​   1.05 ​ ​​
Rotterdam Chemie N.V.

Average* 0.60
​

*An analyst must apply judgment and experience to determine a representative average for the com-
parable companies. This example uses a simple average, but in some situations a weighted average
based on some factor, such as market capitalization, may be more appropriate.

Levering the average unlevered beta for the peer group average, applying
Bayern Chemicals’ target debt-to-equity ratio and marginal tax rate, results
in a beta of 0.86:
​​βBayernChemicals
​ ​ = 0.60​{​ ​1 + ​[​ ​(​ ​1 − 0.38​)​​0.7​]​}​ ​​ = 0.86.​

Using CAPM, the cost of equity of Bayern Chemicals (re) can be calculated
as follows:
re = 4.5% + (0.86)(5.7%) = 9.4%.
The weights for the cost of debt and cost of equity may be calculated as
follows:
wd = 0.41, and we = (1 – 0.41) = 0.59.
The before-tax cost of debt of Bayern Chemicals (rd) is 6.75%:
rd = 4.5% + 2.25% = 6.75%.
As a result, Bayern Chemicals’ WACC is 7.26%:
WACC = (0.41)(0.0675)(1 – 0.38) + (0.59)(0.094)

= 0.0726, or 7.26%.

5 FLOTATION COSTS

explain and demonstrate the correct treatment of flotation costs

When a company raises new capital, it generally seeks the assistance of investment
bankers. Investment bankers charge the company a fee based on the size and type
of offering. This fee is referred to as the flotation cost. In general, flotation costs are
higher in percentage terms for equity issuances than they are for debt. They are also
higher for smaller issuance amounts or for issuances that are perceived to be riskier.
In the case of debt and preferred stock, we do not usually incorporate flotation costs
in the estimated cost of capital because the amount of these costs is quite small, often
less than 1% of the value of the offering.
However, with equity issuance, the flotation costs may be substantial, so we should
consider these when estimating the cost of external equity capital. Average flotation
costs for new equity have been estimated at 7.11% of the value of the offering in the
 © CFA Institute. For candidate use only. Not for distribution.
Flotation Costs 21

United States,1 1.65% in Germany,2 5.78% in the United Kingdom,3 and 4.53% in
Switzerland.4 A large part of the differences in costs among these studies is likely
attributed to the type of offering; cash underwritten offers, typical in the United States,
are generally more expensive than rights offerings, which are common in Europe.
How should flotation costs be accounted for? There are two views on this topic.
One view, which you can find often in textbooks, is to directly incorporate the flo-
tation costs into the cost of capital. The other view is that flotation costs should be
incorporated into the valuation analysis as an additional cost. We will argue that the
second view is preferred.
Consistent with the first view, we can specify flotation costs in monetary terms as
an amount per share or as a percentage of the share price. With flotation costs specified
in monetary terms on a per share basis, the cost of external equity is

​​re​ ​ = ​( ​ 0​ ​− F ​)​​+ g,​

​D​ ​
​_​P 1
(10)

where

re is the cost of equity

D1 is the dividend expected at the end of Period 1

P0 is the current stock price

F is the monetary per share flotation cost

g is the growth rate

As a percentage applied against the price per share, the cost of external equity is

​​re​ ​ = ​[
​P0​ ​​(​1 − f​)​​]
​D​ ​
​_​ 1
​ ​​+ g,​ (11)

where f is the flotation cost as a percentage of the issue price.

EXAMPLE 11

Estimating the Cost of Equity with Flotation Costs

A company has a current dividend of $2 per share, a current price of $40 per
share, and an expected growth rate of 5%.

1. What is the cost of internally generated equity (i.e., stock is not issued and
flotation costs are not incurred)?

Solution:

​​re​ ​ = ​[​ _ ​]​​+ 0.05 = 0.0525 + 0.05 = 0.1025, or 10.25 % .​

$2(1 + 0.05)
​ $40

1 Inmoo Lee, Scott Lochhead, Jay R. Ritter, and Quanshui Zhao, “The Costs of Raising Capital,” Journal
of Financial Research 19 (Spring 1996): 59–71.
2 Thomas Bühner and Christoph Kaserer, “External Financing Costs and Economies of Scale in Investment
Banking: The Case of Seasoned Equity Offerings in Germany,” European Financial Management 9 (June
2002): 249.
3 Seth Armitage, “The Direct Costs of UK Rights Issues and Open Offers,” European Financial Management
6 (2000): 57–68.
4 Christoph Kaserer and Fabian Steiner, “The Cost of Raising Capital—New Evidence from Seasoned Equity
Offerings in Switzerland,” working paper, Technische Universität München (February 2004).
 © CFA Institute. For candidate use only. Not for distribution.
22 Learning Module 1 Cost of Capital-Foundational Topics

2. What is the cost of external equity (i.e., new shares are issued and flotation
costs are incurred) if the flotation costs are 4% of the issuance?

Solution:

​​re​ ​ = ​[​ _
​$40(1 − 0.04) ​]​​+ 0.05 = 0.05469 + 0.05 = 0.1047, or 10.47 % .​
$2(1 + 0.05)

Many experts object to this methodology. Flotation costs are a cash flow that occurs
at issue and they affect the value of the project only by reducing the initial cash flow.
However, by adjusting the cost of capital for flotation costs, we apply a higher cost of
capital to determine the present value of the future cash flows. The result is that the
calculated net present value of a project is less than its true net present value. As a
result, otherwise profitable projects may get rejected when this methodology is used.
An alternative and preferred approach is to make the adjustment for flotation costs
to the cash flows in the valuation computation. For example, consider a project that
requires a €60,000 initial cash outlay and is expected to produce cash flows of €10,000
each year for 10 years. Suppose the company’s marginal tax rate is 40%, the before-tax
cost of debt is 5%, and the cost of equity is 10%. Assume the company will finance
the project with 40% debt and 60% equity. Exhibit 4 summarizes the information on
the component costs of capital.

Exhibit 4: After-Tax Costs of Debt and Equity

Amount
Source of Capital Raised (€) Proportion Marginal After-Tax Cost

Debt 24,000 0.40 0.05(1 − 0.4) = 0.03

Equity 36,000 0.60 0.10

The weighted average cost of capital is 7.2%, calculated as 0.40(3%) + 0.60(10%).

Ignoring flotation costs for the moment and using a financial calculator, we find that
the net present value (NPV) of this project can be expressed as
NPV = Present value of inflows – Present value of the outflows,
or
NPV = €69,591 – €60,000 = €9,591,
where €69,591 is the present value of €10,000 per year for 10 years at 7.2%. Now
suppose flotation costs amount to 5% of the new equity capital: (0.05)(€36,000) =
€1,800. If flotation costs are not tax deductible, the net present value considering
flotation costs is
NPV = €69,591 – €60,000 – €1,800 = €7,791.
If flotation costs are tax deductible, the net present value considering flotation costs is
NPV = €69,591 − €60,000 − €1,800(1-0.4) = €8,511.
Suppose instead of considering the flotation costs as part of the cash flows, we made
an adjustment to the cost of equity. Without showing the calculations, the cost of
equity increases from 10% to 10.2632%, the cost of capital increases from 7.22% to
7.3579%, and the NPV decreases from €9,591 to €9,089. As you can see, we arrive at
different assessments of value using these two methods.
 © CFA Institute. For candidate use only. Not for distribution.
Methods in Use 23

If the preferred method is to deduct the flotation costs as part of the net present
value calculation, why do many textbooks highlight the adjustment to the cost of capital?
One reason is that it is often difficult to identify specific financing associated with a
project. Making the adjustment for flotation costs to the cost of capital is most useful
if specific project financing cannot be identified. A second reason is that by adjusting
the cost of capital for the flotation costs, it is easier to demonstrate how the costs of
financing a company change as a company exhausts internally generated equity (i.e.,
retained earnings) and switches to externally generated equity (i.e., a new stock issue).

METHODS IN USE
We have introduced methods that may be used to estimate the cost of capital for a
6
company or a project, but which methods do companies actually use when making
investment decisions? John Graham and Campbell Harvey (2002) surveyed a large
number of CFOs to find out which methods they prefer. Their survey revealed the
following:
■ The most popular method for estimating the cost of equity is the capital
asset pricing model.
■ Few companies use the dividend discount model (which we did not cover) to
estimate the cost of equity.
■ Publicly traded companies are more likely to use the capital asset pricing
model than are private companies.
■ In evaluating projects, the majority of CFOs use a single company cost of
capital, but a large portion apply some type of risk adjustment for individual
projects.
Their survey also revealed that the single-factor capital asset pricing model is the
most popular method for estimating the cost of equity. The second and third most
popular methods, respectively, are average stock returns and multifactor return models.
The lack of popularity of the dividend discount model indicates that this approach,
although once favored, has lost its appeal in practice.
In a survey of publicly traded multinational European companies, Franck Bancel
and Usha Mittoo (2004) provided evidence consistent with the Graham and Harvey
(2002) survey. They found that over 70% of companies use the CAPM to determine
the cost of equity; this finding is similar to the 73.5% of US companies that use the
CAPM. In a survey of both publicly traded and private European companies, Dirk
Brounen, Abe de Jong, and Kees Koedijk (2004) confirmed the result of Graham and
Harvey that larger companies are more likely to use the more sophisticated methods,
such as CAPM, in estimating the cost of equity. Brounen, de Jong, and Koedijk found
that the use of the CAPM was less popular for their sample (ranging from 34% to
55.6%, depending on the country) than for the other two surveys, which may reflect
the inclusion of smaller, private companies in their sample.
We learn from the survey evidence that the CAPM is a popular method for
estimating the cost of equity capital and that it is used less often by smaller, private
companies. The latter result is not surprising, because of the difficulty in estimating
systematic risk in cases in which the company’s equity is not publicly traded.
 © CFA Institute. For candidate use only. Not for distribution.
24 Learning Module 1 Cost of Capital-Foundational Topics

SUMMARY
In this reading, we provided an overview of the techniques used to calculate the cost
of capital for companies and projects. We examined the weighted average cost of
capital, discussing the methods commonly used to estimate the component costs of
capital and the weights applied to these components.
■ The weighted average cost of capital is a weighted average of the after-tax
marginal costs of each source of capital: WACC = wdrd(1 – t) + wprp + were.
■ The before-tax cost of debt is generally estimated by either the
yield-to-maturity method or the bond rating method.
■ The yield-to-maturity method of estimating the before-tax cost of debt uses
the familiar bond valuation equation. Assuming semi-annual coupon pay-
ments, the equation is

[t=1​(​1 + _
​2 ​)​​]
PM ​T1​ ​ PM ​Tn​ ​ n PM ​Tt​​
​​P0​ ​ = _ _ _ _​ ​​+ _
FV FV
​ ​r​d​ ​+ … + ​ r​d​ n ​+ ​ r​d​ n ​ = ​​ ​∑ ​ ​ ​r​d​ n .​​
​(​1 + ​2 ​)​
_ ​_ ​_ ​r​ ​ t
​(​1 + ​2 ​)​ ​ ​(​1 + ​2 ​)​ ​ _ d
​(​1 + ​2 ​)​ ​

We solve for the six-month yield (rd/2) and then annualize it to arrive at the
before-tax cost of debt, rd.
■ Because interest payments are generally tax deductible, the after-tax cost is
the true, effective cost of debt to the company. If a yield to maturity or bond
rating is not available, such as in the case of a private company without
rated debt or a project, the estimate of the cost of debt becomes more
challenging.
■ The cost of preferred stock is the preferred stock dividend divided by the
current preferred stock price:

​Dp​ ​
​​rp​ ​ = _
​​P​ ​​.​
p

■ The cost of equity is the rate of return required by a company’s common

stockholders. We estimate this cost using the CAPM (or its variants).
■ The CAPM is the approach most commonly used to calculate the cost of
equity. The three components needed to calculate the cost of equity are the
risk-free rate, the equity risk premium, and beta:

​E​(​ ​Ri​​)​​ = R
​ F​ ​+ β​ i​​​[​E​(​ ​RM
​ ​)​​− ​RF​ ​]​​.​

■ In estimating the cost of equity, an alternative to the CAPM is the bond

yield plus risk premium approach. In this approach, we estimate the
before-tax cost of debt and add a risk premium that reflects the additional
risk associated with the company’s equity.
■ When estimating the cost of equity capital using the CAPM, if we do not
have publicly traded equity, we may be able to use a comparable company
operating in the same business line to estimate the unlevered beta for a
company with similar business risk, βU:

[ 1 + (1 − t ) ​E ​]
​ ​ = ​βE​ ​​ _
​​βU ​ 1
D ​ ​​.​
_
 © CFA Institute. For candidate use only. Not for distribution.
Methods in Use 25

Then, we lever this beta to reflect the financial risk of the project or
company:

​ ​​[​1 + (1 − t ) _
​​βE​ ​ = ​βU E ​]​​.​
​D

■ Flotation costs are costs incurred in the process of raising additional capital.
The preferred method of including these costs in the analysis is as an initial
cash flow in the valuation analysis.
■ Survey evidence tells us that the CAPM method is the most popular method
used by companies in estimating the cost of equity. The CAPM method
is more popular with larger, publicly traded companies, which is under-
standable considering the additional analyses and assumptions required in
estimating systematic risk for a private company or project.
 © CFA Institute. For candidate use only. Not for distribution.
26 Learning Module 1 Cost of Capital-Foundational Topics

REFERENCES
Bancel, Franck, Usha Mittoo. 2004. “Cross-Country Determinants of Capital Structure Choice:
A Survey of European Firms.” Financial Management 33 (4): 103–32.
Blume, Marshall. 1971. “On the Assessment of Risk.” Journal of Finance 26 (1): 1–10.
Brounen, Dirk, Abe de Jong, Kees Koedijk. 2004. “Corporate Finance in Europe: Confronting
Theory with Practice.” Financial Management 33 (4): 71–101.
Dimson, E., P. Marsh, M. Staunton. 2018. “Credit Suisse Global Investment Returns Yearbook
2018” (February).
Fernandez, Pablo, Vitaly Pershin, Isabel Fernández Acin. 2018. “Market Risk Premium and
Risk-Free Rate Used for 59 Countries in 2018: A Survey.” Available at SSRN: https://ssrn.com/
abstract=3155709.
Graham, John R., Campbell R. Harvey. 2002. “How Do CFOs Make Capital Budgeting and
Capital Structure Decisions?” Journal of Applied Corporate Finance 15 (1): 8–23.
Graham, John R., Campbell R. Harvey. 2018. “The Equity Risk Premium in 2018.” Working paper
(27 March). Available at https://ssrn.com/abstract=3151162.
Pinto, Jerald E., Thomas R. Robinson, John D. Stowe. 2019. “Equity Valuation: A Survey of
Professional Practice.” Review of Financial Economics 37 (2): 219–33.
Siegel, Jeremy J. 2005. “Perspectives on the Equity Risk Premium.” Financial Analysts Journal
61 (6): 61–73.
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 'Never till I have held you to my breast and kissed you,' he said.
'That never, never!' she gasped. She got her hands on his breast
and forced his arms asunder behind her.
'Ha, ha! strong,' he laughed, 'but not strong as I.' He gripped
her wrists and bent her arms back. She threw herself on the ground,
he drew her up. She flung herself against the chair, crushing his
hand against the chimney-piece, so that he let go with it for an
instant. She groped about with her free hand, in the dark, for some
weapon, she grasped something. He cursed her for the pain she had
given him, and attempted again to seize her hand. In a moment she
had struck him—him the coward assailant, him the thief, him the
murderer—between the brows with the weapon her hand had taken.
It was a blow with her whole force. There followed a crash of glass,
then a sense as of her hand being plunged into fire. Then a shriek
loud, tearing through roof and wall, loud, agonised, as only a man or
a horse can utter in supreme moments of torture; and Rebow fell on
the floor, writhing like a worm, with his hands over his face and
eyes.

CHAPTER XXV.
IN THE DARKNESS.

Day by day Elijah Rebow lay, or sat, in the darkened oak parlour
with his eyes bandaged, a prey to wrath, pain, despair. The vitriol
from the broken vial had got into his eyes, and there was reason to
fear had blinded them.
 He was obliged to have the burning balls kept from the light,
but he raged under the obligation. He wanted to see, he could not
be patient under restraint. He could ill understand that in all things
he might not have his way, even in such a matter as this. He chafed
also at having been conquered by Glory. That she should have defied
and beaten him, and beaten him in such a crushing manner, cut his
pride to the quick.
None knew how the accident had occurred save himself and
Mehalah. To the doctor he had merely said that in getting the vitriol
bottle from the shelf, it had fallen and broken on his forehead.
Mrs. Sharland remained in as complete ignorance of the truth as
the rest, and her lamentations and commiserations, poured on Elijah
and her daughter, angered him and humiliated her. Mehalah had
suffered in mind agonies equal in acuteness to those endured in
body by Elijah.
Horror and hatred of herself predominated. She had destroyed,
by one outburst of passion, the eyesight of a man, and wrecked his
life. What henceforth for thirty or forty years could life be to Rebow?
—to one who could not endure existence without activity? She had
rendered him in a moment helpless as a babe, and dependent on
herself for everything. She must attend to his every want, and
manage the farm and his business for him. By a stroke, their relative
positions were reversed. The wedding night had produced a
revolution in their places of which she could not have dreamed. She
felt at once the burden of the responsibilities that came upon her.
She was called upon by those on the farm to order and provide for
everything connected with it. She had to think for the farm, and
think for the master into whose position she had forced her way.
 She hated herself for her rash act. She hated the man whom
she had mutilated, but more herself. If by what she had done she
had in one sense made herself master, in another she had cast
herself into bondage. By the terrible injury she had inflicted on
Rebow she had morally bound herself to him for life to repair that
injury by self-devotion. Had it been possible for her to love him,
even to like him, this would have been light to her, with her feminine
instinct, but as it was not possible, the slavery would be
inexpressibly painful.
Love will hallow and lighten the most repulsive labours, the
most extreme self-sacrifice, but when there is no love, only
abhorrence, labour and self-sacrifice crush mentally and morally. She
must bear the most fierce and insulting reproaches without an
attempt to escape them, she had in part deserved them. These she
could and would endure, but his caresses!—no! however deeply she
might have sinned against him, however overflowing her pity for his
helpless condition might be, she could not tolerate affection from the
man who by his own confession merited her profound loathing. He
had taken an unoffending man, and had imprisoned him and blinded
his reason by cruelty; it seemed to her as if Providence had used her
hand to exact a just retribution on Rebow by condemning him to an
equally miserable condition. The recompense was justly meted, but
would that it had been dealt by another hand!
In one particular she was blameless, and able to excuse herself.
She had acted without intent to do bodily harm, and in ignorance of
the weapon she had used. She had been carried away by the instinct
of self-preservation, and had taken up what was readiest at hand,
without a wish to do more than emancipate herself from the grasp
of the man she detested. He had brought the consequences on his
own eyes by his own act.
But though she quite recognised that he had done this, and that
he richly deserved the consequences, yet she could not relieve her
conscience from the gnawings of self-reproach, from the scalding
blush of shame at having executed a savage, unwomanly vengeance
on the man who had wronged her. Had her victim been a woman
and a rival, she would perhaps have gloried in her act; but the
female mind is perverse in its twists and complexion, and it will
tingle with pain for having hurt a man, however little that man may
be loved, when it would plume itself for having done the same to a
woman who has been a friend. A woman must think and act rightly
towards a man, but can do neither towards one of her own sex.
Mehalah's bosom was a prey to conflicting emotions. She pitied
Elijah, and she pitied George. Her deep pity for George forced her to
hate his torturer, and grudge him no suffering to expiate his offence.
When she thought of what George de Witt must have endured in the
vault, of his privations there, of the gradual darkening and
disturbance of his faculties, and then of how Elijah had stepped
between him and her, and spoiled their mutual dream of happiness,
and ruined both their lives, the hot blood boiled in her heart, and
she felt that she could deal Rebow the stroke again, deliberately,
knowing what the result must be, as a retributive act. But when she
heard him, as now, pacing the oak parlour, and in his blindness
striking against the walls, her pity for him mounted and overlapped
her wrath. Moreover, she was perplexed about the story of George's
imprisonment. There was something in it she could not reconcile
with what she knew. Elijah had confessed that on the night of
George's disappearance he had enticed the young man to Red Hall,
made him drunk or drugged him, and then chained him in the vault,
in the place of his own brother who had died. It was Rebow and not
De Witt who, that same night, had appeared at her window, driven
in the glass and flung the medal at her feet. But was this possible?
She knew at what hour George had left the Mussets' shop, and she
knew about the time when the medal had been cast on the floor
before her. It was almost incredible that so much had taken place in
the interval. It was no easy row between Red Hall and the Ray, to be
accomplished in half an hour.
Surely, also, had George De Witt been imprisoned below, he
could have found some means to make himself heard, to
communicate with the men about the farm, in the absence of
Rebow. Would a few months in that dark damp cell derange the
faculties of a sane man?
Mehalah lifted the trap and went down. The vault was a cellar
not below the soil, but with floor level with the marsh outside, or
only slightly beneath. It had a door fastened from within by a bolt,
but also provided with a lock; and there was the circular window
already described. The shutter had not been replaced, and the
sunlight entered, and made the den less gloomy and horrible than
Mehalah had conceived it to be. She found the staple to which the
chain had been attached, away from the door and the window. It
was obvious how the maniac had got loose. The chain had been
attached to the staple by a padlock. Elijah sometimes unlocked this,
when he was cleaning the straw from the cell and supplying fresh
litter. He had carelessly turned the key in the lock, and left it
unfastened. The madman had found this out after Rebow was gone,
and had taken advantage of the circumstance to break out at the
window. The chain and padlock, with the key in it, were now hung
over the fireplace in the hall, mocking the inscription below, 'When I
take hold, I hold fast.'
Mehalah seated herself in the window of the hall, and took up
some needlework. Elijah was still pacing the parlour and beating
against the opposite walls, muttering curses when he struck the oak
panels. Presently she heard him groping along the walls for the door,
and stumbling over chairs. He turned the handle and entered the
hall.
He stood before her in the doorway of the darkened chamber,
with extended quivering hands, his head bowed, his eyes covered
with a thick bandage. He wore his red plush waistcoat and long
brown coat. His dark hair was ruffled and stood up like rushes over a
choked drain. He turned his head aside and listened. Mehalah held
her breath.
'You are there,' he said. 'Although you try to hide from me, I
know you are there and watching me. I am in the dark but I can
see. I can see you always and everywhere, with your eyes—great
angry brown eyes—on me, and your hand lifted to strike me into
endless night.'
Mehalah did not speak. Why should she? She could say nothing
that could do either any good.
'Have you put the hot fire to your tongue and scorched it out as
you have put it to my eyes?' he asked. 'Can't you speak? Must I sit
alone in darkness, or tramp alone up and down in black hell, feeling
the flames dance in my eye-sockets, but not seeing them, and have
no one to speak to, no one to touch, no one to kick, and beat, and
curse? Go out and fetch me a dog that I may torture it to death and
laugh over the sport. I must do something. I cannot tramp, tramp,
and strike my head and shoulders against the walls till I am bruised
and cut, with no one to speak to, or speak to me. By heaven! it is
bad enough in Grimshoe with two in the shiphold mangling each
other, but there is excitement and sport in that. It is worse in that
wooden hold yonder, for there I am all alone.'
He stopped speaking, and began to feel round the room. He
came to the chimney and put his fingers into the letters of the
inscription. 'Ha!' he muttered, 'When I lay hold, I hold fast. I laid
hold of you, Mehalah, but I have not let go yet, though I have
burned my fingers.'
This was the first time he had called her by her Christian name.
She was surprised.
'Mehalah!' he repeated, 'Mehalah!' and then laughed bitterly to
himself. 'You are no more my Glory. There is no Glory here for me;
unless, in pity for what a ruin you have made, you take me to your
heart and love me. If you will do that I will pardon all, I will not give
a thought to my eyes. I can still see you standing in the midst of the
fire, unhurt like a daughter of God. I do not care. I shall always see
you there, and when the fire goes out and only black ashes remain,
I shall see you there shining like a lamp in the night, always the
same. I do not care how many years may pass, how old you may
wax, whether you may become bent and broken with infirmities, I
shall always see my Glory with her rich black shining hair, her large
brown eyes, and form as elastic and straight as a pine-tree. I shall
see the blue jersey and the red cap and scarlet skirt.' He raised his
hands and wrung them in the air above his head: 'What do I care for
other sights? These long flat marshes have nothing beautiful in
them. The sea is not here what it is on other coasts, foaming,
colour-shifting like a peacock's neck; here it is of one tone and grey,
and never tosses in waves, but creeps in like a thief over the shallow
mud-flat, and babbles like a dotard over the mean shells and clots of
weed on our strand. There is nothing worth seeing here. I do not
heed being blinded, so long as I can see you, and that not you nor
all your vitriol can extinguish. Heat skewers white hot in the fire, and
drive them in at the eye-sockets through all obstruction into the
brain, and then, perhaps, you will blind me to that vision. Nothing
less can do it. Pity me and love me, and I forgive all.'
He crept past the chimney-piece and was close to the window.
He touched Mehalah with one hand, and in a moment had her fast
with both.
'I cannot love you,' she said, 'but I pity you from the depth of
my soul, and I shall never forgive myself for what I have done.'
'Look here!' he snatched his bandages away and cast them
down. 'This is what you have done. I have hold of you, but I cannot
see you with my eyes. I am looking into a bed of wadding, of white
fleeces with red ochre smears in them, rank dirty old fleeces
unsecured—that is all I see. I suppose it is the window and the
sunshine. I feel the heat of the rays; I cannot see them save as
streaks of wool.'
'Elijah!' exclaimed the girl, 'let me bandage your eyes again. You
were ordered to keep all light excluded.'
'Bah! I know well enough that my eyesight is gone. I know what
you have done for me. Do you think that a few days in darkness can
mend them? I know better. Vitriol will eat away iron, and the eyes
are softer than iron. You knew that when you poured it on them.'
'I never intended to do you the harm,' said Mehalah
passionately, and burst into tears. He listened to her sobbing with
pleasure.
'You are sorry for me?'
'I am more than sorry. I am crushed with shame and grief for
what I have done.'
'You will love me now, Mehalah.'
She shook her head and one of her tears fell on his hand; he
raised his hand and put it to his eyes; then sighed. 'I thought one
such drop would have restored them whole as before. It would, had
there been sweetness in it, but it was all bitter. There was only anger
with self and no love for me. I must bide on in blackness.' He put his
hands on each side of her head, twisted his thumbs resting on her
cheek-bones, and her unrestrained tears ran over them.
He stood quite still.
'This is the best medicine I could get,' he said; 'better nor all
doctor's messes. To listen to your heart flowing over, to feel your
warm tears trickle, does me good. In spite of everything, Glory! I
must love you, and yet, Mehalah! I have every cause to hate you. I
have made you, who were nothing, my wife, mistress of my house
and estate, with a property and position above everyone else in
Salcott and Virley, equal to any of the proud yeomen's wives on
Mersea Isle. I have made a home for your mother, and in return you
have plunged me in eternal night, and deny me your love.'
'Let us not recriminate,' said Mehalah through her tears, 'or I
should have enough to charge you with. I never sought to be your
wife. You drove me into the position in spite of my aversion to it; in
spite of all my efforts to escape. You have wounded me in a cruel
and cowardly manner past forgiveness. You have ruined my life and
all my prospects of happiness. George——'
He shook her furiously.
'I will not listen to that name,' he said through his teeth.
'You could bear to hold him in chains there below,' she
answered.
'You said, Let us not recriminate, and you pour a torrent of
recriminations over me,' he gasped. 'If I have wronged you, you
have redressed all with one vial of vitriol in the eyes, where man is
most sensitive. With that firejuice you purged away all the past
wrongs, I expiated in that liquid flame all the evil I had done you.
You don't know what I have suffered. You have had no such
experience of pain as to imagine the tortures I have undergone. If
the anguish were all, it would be enough atonement; but it is not all.
There is the future before me, a future of night. I shall have to trust
to someone to do everything for me, to be eyes, and hands, and
feet to me. Whom can I trust? How do I know that I shall not be
deserted, and left to die in my darkness, a prey to ravenous men? If
you loved me, then I could lean on you and be at peace. But you do
not love me, and you will leave me when it suits your pleasure.'
'No, Elijah,' said Mehalah sadly; 'that I never will do. I have
robbed you of your sight. I did it unwittingly, in self-defence,
perhaps also in anger at knowing how cruelly, wickedly, cowardly
you had behaved to me and to another whom I loved.'
'Whom you love still!' with a cry of rage.
 'One whom I loved,' repeated Mehalah, sadly; 'and I must atone
for my mad act as far as lies in my power. I will stay by you. I will
never forsake you.'
'Listen to me, Mehalah,' said Elijah, with concentrated
vehemence; 'you know what was said—that the person you loved
went out in a boat and was lost. The body was never found. Should
the man turn up again.'
'That is impossible.'
'I don't care for impossibilities. I live now in a dream-world
where there is no line drawn between the possible and the
impossible. Should he reappear, what then?'
'Still I would remain at my post of duty,' said the girl, humouring
his fancy.
'The post of duty, not of love,' he muttered.
'I said duty,' she replied; 'I will never leave that.'
His thumbs twitched on her cheek-bones and worked their way
to the corners of her eyes; she sharply withdrew her head.
He laughed. 'You thought I was going to gouge your eyes out
with my thumbnails,' he said, 'that I was going to repay you in kind.
No, I was not; but should the dead return to life and reclaim you, I
may do it. You cannot, you shall not escape me. You and I, and I
and you, must sink or swim together. Say again, Mehalah, that you
will stand by me.'
'I promise it you, Elijah, I promise it you here solemnly, before
God.' She sank on her knees. 'I have brought you unwittingly into
darkness, and in that darkness I will hold to you and will cherish
you.'
 'Ha!' he shouted. 'At the altar you refused to swear that. To
love, cherish, and obey is what the parson tried to make you say;
but all you swore to was to obey, you denied the other, and now you
take oath to cherish. The wheel of fate is turning, and you will come
in time to love where you began to obey and went on to cherish.'

CHAPTER XXVI.
THE FORGING OF THE RING.

Mrs. Sharland was failing. The excitement of the marriage had

roused her to activity, but when that was over she relapsed, her
energy evaporated, and she took to her bed with the avowed
intention of not leaving it again, except for a christening in the
family, till carried to her grave. She did not understand Mehalah, she
fretted because the arrangements after the eventful day remained
the same as before; her daughter shared her room and kept as
much away from Elijah as was possible, showed him none of the
love of a wife to her husband, and was distressed when spoken to
by her new name.
'You are either Mistress Rebow or you are not,' said the old
woman peevishly to her daughter one night, in their room, 'and if
you are not, then I don't understand what the ceremony in the
church was for. You treat Elijah Rebow as coldly and indifferently as
if he were naught to you but master, and you to him were still hired
servant. I don't understand your goings on.'
 'He and I understand each other, that is enough,' answered
Mehalah. 'I have married him for his name and for nothing else. In
no other light will I regard him than as a master: I told him when I
agreed to go to church with him that I would be his no further than
the promise to obey went; I take his name to save mine—that is all.
He is not my husband, and never shall be, in any other way. I will
serve him and serve him devotedly, but not give him my love. That I
cannot give. I gave my heart away once for all, and it has not been
restored to me.'
'That is all nonsense,' said Mrs. Sharland. 'Didn't I love Charles
Pettican, and weren't we nigh coming to a declaration, only a fit of
the ague shivers cut it short? I married your father, and loved him
truly as a good wife and not as a hired servant, for all that.'
'Elijah and I understand each other,' answered Mehalah. 'I
suppose there is something of truth in what he says over and over
again, that he and I are different from others, and that there's none
can understand us but our two selves.'
'Then you are made for one another.'
'So he says, but I will not believe it. No. That cannot be. Some
have peace and happiness drop into their lap, others have to fight
their way to it, and that is our fate. But that we shall find it in each
other, that I never will admit. In George——' she covered her eyes,
and left her sentence unfinished.
The charge of Mrs. Sharland was, to some extent, unjust.
Mehalah did attend to Elijah with as much care and as assiduously
as she was able, considering the amount of work which had
devolved upon her. Her mother was ill and in bed, Elijah helpless.
She had to see after and direct everything about the farm and
house, beside ministering to the two invalids. Consequently she was
unable to devote much time to Elijah, but whenever she had a few
moments of relief from work she devoted them to him. She took her
needlework either to him in the oak parlour, or brought him into the
hall. She had now somewhat lightened her labours by engaging a
charwoman, and was therefore more able than before to be with
Rebow and her mother. Each complained if left long alone, and she
had much difficulty in portioning her time between them. She tried,
but tried in vain, to induce her mother to make an effort and come
downstairs, so that she might sit with both at once; this would save
her from distraction between two exacting and conflicting claims,
and some restraint would be placed on the intercourse between
Rebow and herself by the presence in the room of a third party.
Elijah was not entirely blinded, he was plunged not in darkness
but in mist. He could see objects hazily, when near; he could
distinguish figures, but not faces, when within a few yards of him,
but nothing distant. The wall and a black cloud on the horizon were
equally remote to his vision.
He wandered about, with a stick, and visited his cattle sheds
and workmen; or sat under the south wall of his house in the sun.
The pump was there, and to it Mehalah sometimes came. He
listened for her step. He could distinguish her tread from that of the
charwoman. He took no notice of this woman, though she came up
to him occasionally and said a few commiserating words.
The men thought that he was gentler in his affliction than he
had been before. He did not curse them, as had been his wont. He
asked about the cattle, and the farm, and went his way. Mehalah
also noticed that he was less fierce; she was able also to attribute
this softening to its right cause, to her own influence. He was, to
some extent, happy, because she was often with him, sought him
instead of shunning him, spoke to him kindly, instead of rebuffing
him when he addressed her, and let him know and feel that she
thought of him, and was endeavouring to make him comfortable in
his great deprivation.
As he sat in the sun and looked up at the bright orb, which he
saw only as a nebulous mass of light, she was ever present before
his inward eye, she in her pride and beauty. He did not think; he sat
hour by hour, simply looking at her—at the image ever before him,
and listening for her step or voice. An expression of almost content
stole across his strongly marked features, but was occasionally
blurred and broken by an uneasy, eager, enquiring look, as if he
were peering and hearkening for something which he dreaded. In
fact, he was not satisfied that George De Witt would never reappear.
Had he been set at rest on this point, he could have been happy.
Mehalah was touched by his patience, his forgiveness of the
irreparable wrong she had done him. He had said that if she loved
him he would pardon all. He was ready to do this at a less price;
though he craved for her love, he was contented, at least for the
present, with her solicitude. He had been accustomed to open
hostility and undisguised antipathy. Now that he met with
consideration and tenderness from her, he became docile, and a
transformation began to be operated in his nature. Love him, she
could not, but she felt that but for what he had done to George, she
could regard him without repugnance. Pity might ripen into
friendship. Into a deeper and more rich feeling it never could, for he
had barred the way to this possibility by his dealing with De Witt.
 She ventured occasionally to approach the subject, but it always
produced such agitation in the manner of Rebow that she was
obliged to desist from seeking explanation of the particulars which
perplexed her. The slightest allusion to George De Witt troubled the
master of Red Hall, made his face darken, and brought on an access
of his old violence, from which he did not recover for a day or two.
Mrs. De Witt came to see him.
'Lawk a day!' she said; 'what a job to find you in this
predicament!'
He turned his whitened eyes on her, with a nervous twitch in
the muscles and a tremour of the lips. 'Well! What news?'
'News!' echoed the lady; 'dear sackalive! who'd expect to find
news in Mersea? you might as well drag for oysters in a horsepond.'
He was satisfied, and let her talk on without attending to her.
A few days later, he called the charwoman to him as she was
going to the pump.
'What is your name?'
'Susan Underwood. I'm a married woman, with three small
children, and another on its way.'
He fumbled in his pocket, and took out a crown.
'Any news?—from Mersea, I mean.'
'I don't come from Mersea. Thank your honour all the same.'
'But if there were news there it would get to Virley or Salcott, or
wherever you live.'
'It would be sure. I did hear,' she said, 'that Farmer Pooley has
been a-wisiting a little more nor he ought at widow Siggars' cottage,
her as has a handsome daughter, and so, they do say, has Farmer
Pudney; and the other day they met there, and was so mad each to
find the other, that the one up with his hunting whip and the other
with his bible and knocked each other down, and each had to be
carried home on a shutter.'
'Go and tell those tales to the old woman upstairs. I have no
patience to listen to them. That's the sort of garbage women feed
on, as maggots on rotten meat.'
'But it is true.'
'Who cares whether true or not? It is all the same to me. Has
anyone arrived at Mersea?'
'Not yet, sir, but they do say that the parson's wife has
expectations.'
'Go back to the kitchen,' growled Elijah, and relapsed into his
dream.
A few minutes after, Mehalah came out, and seated herself on
the bench beside him. She was knitting. He put out his hand and felt
her, and smiled. He raised his hand to her head.
'Glory! when you wear the red cap in the sun I know it, I see a
scarlet light like a poppy, and it pleases me. Let me hold the ball,
then I can feel every stitch you take with your fingers.'
She put the wool gently into his palm; and began to talk to Mm
concerning the farm. He listened, and spoke in a tone and with a
manner different from his habit formerly.
Presently his hand stole up the thread, and he caught her
fingers and drew her hand down on her lap. Her first impulse was to
snatch it away, but she conquered it, and let him feel over her hand
without a movement of dislike.
'You have not yet a ring,' he said; 'you have no gold wedding
circle like other married women.'
 'Our union is unlike all others,' she said.
'That is true; but you must wear my ring. I shall not be happy
till you do. I shall think you will cast me off unless I can feel the ring
that has no ending round your finger. Where is the link with which I
married you?'
'I have it here,' she said; 'I have not cast it off, and I shall not
cast you off. I have fastened it by a string and carry it in my bosom.'
He seemed pleased. 'You wear it for my sake.'
'I wear it,' she replied, truthfully, 'because I took a solemn oath
on that day, and I will not go from it. What I undertook that I will
fulfil, neither more nor less. What I did not promise I will not do,
what I did undertake that I will execute.'
'And you bear the ring in your bosom——'
'As a reminder to me of my promise. I will not be false to myself
or to you. Do not press me further. You know what to expect and
what not to expect. If I could love you I would; but I cannot. I did
not promise that then and I will not promise it now, for I know the
performance is out of my power.'
'You must wear the wedding ring on your finger.'
'I cannot wear this link, it is too large.'
'I will get you a gold ring, such as other women wear.'
'No. I cannot wear a lie; the gold ring belongs to the perfect
marriage, to the union of hearts. It befits not ours.'
'You are right,' he said, and sighed. He still held her hand; she
made a slight effort to withdraw it, but he clasped the hand the
tighter.
'Let me touch and hold you, Glory,' he said. 'Remember I can no
more see you, except mistily. You must allow me some
compensation. I know what you are now, sitting here in the sun,
with your hair full of rich coppery gleams, and your eyes full of light
and darkness at once, and your cheek like a ripe apricot. I know
what you are, splendid, noble, as no other girl in the whole world;
but you have shut my eyes, that I may not see you, so allow me, at
least, to feel you.' He paused. Then he went on: 'You are right, our
union is unlike any other, as you and I are different from all others in
the world. The married life of some is smooth and shining and
rustless like the gold, but ours is quite contrary, it is rough and dark
and full of blisters and canker. It may be different some day——' he
turned his dim eyes enquiringly at her, 'but not now, not now.
Nevertheless as the ring is without an end so is our union. Give me
the link of iron, Glory, and come with me to the forge. I will beat out
a bit of the metal into a ring, one small enough and light enough for
you to wear.'
He got up, and holding her hand, bade her lead him to the
forge.
Near the bakehouse was a small smithy, fitted up with all
necessary appliances. Rebow was a skilful workman at the anvil, and
shod his own horses, and made all that was needed in iron for the
house and farm.
Mehalah conducted him to the shop, and brought fire from the
kitchen for the forge, she worked the bellows and blew the fire into
size and strength, whilst Elijah raked the coals together.
'Where is the link, Glory?' he asked, and went up to her. He put
his hand to her neck, before she did, and drew out of her bosom
something.
 'That is not the link, Elijah,' she said; 'it is my medal—the medal
that——'
He uttered a fierce cry, and wrenching it off, dashed it on the
ground. He would have stamped on it had he been able to see it.
Mehalah's cheek flushed, but she said nothing. She saw where
the coin had rolled. She stooped, picked it up, impressed a kiss upon
it, and hid it once more in her bosom.
'Here is the iron link,' she said; he took it from her sullenly.
The flame gleamed up blue above the wetted coal, and glared
out white through the crevices in the clot, as the bellows panted,
and Rebow drew the coals together or broke into the glaring mass
with an iron rod.
'I heard a preacher once take as his text,' said he, 'Our God is a
consuming fire; and he told all in the chapel that this was writ in
Scripture and therefore must be true to the letter, for God wrote it
Himself, and He knew what He was better than any man. He said
that fire warms and illumines at a distance, but if you come too close
it dazzles and burns up. And he told us it was so with God. You can't
keep too far off of Him to be comfortable and safe; the nearer you
get, the worse it is for you; and to my thinking that is Hell, when
you get sucked into the very core of the fire in the heart of God. You
must be consumed because you are not divine, fire alone can live in
fire; most folks are clay and water, and they are good enough, they
get light and warmth, but when they die they burn up like this dock
of coke. But there are other folk, like you and me, Glory! who are
made of fire and clay; it takes but a word or a thought to make us
roar and blaze and glow like this furnace. There is passion in us—
and that is a spark of the divine. I do not care what the passion be,
love or hate, or jealousy or anger, if it be hot and red and consuming
so that it melts and burns all that opposes it, that fiery passion is of
God and will live, live on for ever, in the central heart and furnace,
which is God. When you and I die, Glory! and are sucked into the
great fiery whirlpool, we shall not be burnt up altogether, but
intensified. If I love you with fiery passion here I shall love you with
fiery passion ten thousand times hotter hereafter; my passion will
turn to glaring white heat, and never go out for all everlasting, for it
will be burning, blazing in God who is eternal. If you hate me, you
will be whirled in, and your fury fanned and raked into a fiery
phrenzy which will rage on for ages on ages, and cannot go out, for
it will be burning in the everlasting furnace of God. If I love, and you
hate with infinite intensity for an infinity of time—that is Hell. But if
you love and I love, our love grows hotter and blazes and roars and
spurts into one tongue, cloven like the tongues at Pentecost, twain
yet one, and that is Heaven. My love eating into yours and encircling
it, and yours into mine, and neither containing nor consuming the
other, but going on in growing intensity of fiery fury of love from
everlasting to everlasting, that is Heaven of Heavens.'
He was heating the link, held between the teeth of long
shanked pincers, and then withdrawing it, and forging it on the anvil
as he spoke.
'Glory!' he said; 'tell me, you do not hate me?'
She hesitated.
'Glory!' he repeated, and laid hammer and pincer on the anvil,
and leaned his head towards her, as she shrank into the dark corner
by the bellows, 'Glory! tell me, you do not hate me.'
 'Elijah,' she said, 'I must be candid with you. When I think of
what, by your own confession, you have done to him whom I loved
more than all the world——'
He raised his hammer and brought it down on the link, cutting it
in half, and sending one fiery half across the smithy.
'When I think of what you have done to him, I feel that I do
hate you, and that I have every cause and right to hate you. I could
forgive everything else. I have turned over in my mind all that you
have done to me, the cruel way in which you worked till you had
brought me within your power, the heartless way in which you got
my good name to be evil spoken of, and drove me out of self-
defence to take your hand before the altar of God, I have thought of
all this, and I feel that my act—unintentional though it was—yet my
act, which has blinded you, has expiated all those offences. You
have wronged me, and I have wronged you. I have ruined your life,
but you have also ruined mine. We are quits so far. You have my
frank forgiveness. I blot out all the past, as far as it concerns me,
from my memory. It shall no more rankle in my heart. You have
shown me a generous forgiveness of my misdeed, and I would
imitate you. But what you did to George is not to be expiated. You
sinned against him more terribly, more wickedly than against me,
and he alone can pardon you. That I cannot forgive; and for that
crime I must still hate you.'
He stood trembling—a strange weakness came over him—he
was not angry, savage, morose; he seemed a prey to fear and
uncertainty.
'Tell me, tell me truly, Glory! Does that alone prevent you from
loving me? Had I never done what I said I had done, could you love
me?'
'I do not say that,' she replied. 'As I have told you before, I gave
my heart once for all to George De Witt. I never could love you with
my fresh full heart, as a woman should love her husband, but I feel
that I could like you as a friend. I do pity you. God knows how
bitterly I have suffered from remorse for what I did unwittingly, and
how sincere I am in my repentance and desire to deal tenderly and
truly by you, Elijah. I feel sometimes as if I could like you; I do
acknowledge that you and I stand apart from others, and alone can
understand each other; but then that great crime of your life against
George rises up before me and drives back my rising compassion.'
Rebow worked again at the link, beating out the fragment into a
wire, and cutting it again. He was thinking whilst he wrought.
'Sooner or later,' he muttered at last, 'all will out.'
He worked with difficulty, and slowly, as he could not see, and
was obliged to feel the iron, and cool it repeatedly to ascertain
whether it was as he desired it.
'Look here, Glory!' he said, 'when iron is taken from the
smelting furnace it is crystalline and brittle; there is no thread and
texture in it, but we burn it and beat it, and as we work we beat our
stubborn purpose into the metal, and it is the will of the smith which
goes through his arm and hammer into the iron and converts it to
steel; he drives his will into the metal, and that becomes the fibre in
it. You don't find it so in nature. The human soul must part with
something and transfuse it into the inanimate iron, and there it will
lie and last, for the will of man is divine and eternal. It is much the
same with all with which we have to do. I have spent time and
labour over you, and thought and purpose have been consumed in
making you my wife; they are none of them lost, they are all in you,
they have become fibres in your soul. You may not be aware of it,
but there they all are. The more one thinks and labours for the other
the more he ingrafts himself in the nature of the other. I have heard
of sound men having their healthy blood drawn off and injected into
the veins of the sick, and restoring them thus to activity and health.
We are always doing this with our wills, injecting their fire into the
hearts of others, and so by degrees transfusing their natures. You
are pouring yourself into me, and I into you, whether we know it or
not, till in time we are alike in colour and tone and temperature.'
He had worked the piece of steel into a rude ring, not very
cumbrous, and he bade Mehalah try it on her finger. It was too
small. He easily enlarged it, and then got a file to smooth off the
roughnesses.
'I had rather you wore this than a ring of gold,' he said, 'for
there is part of my soul in this iron. I have made it in spite of my
blindness, because I had the will to do so. The whole metal is full of
my purpose, which tinctures it as wine stains water; and with it goes
my resolve that you shall be mine altogether in heart and soul, in
love as well as in pity, for now and for all eternity. You will wear that
on your finger, the finger that has a nerve leading from the heart.
Stretch out your hand, Glory, and let me put it on. Stretch out your
hand over the hearth, above the fire, our God is a consuming fire,
and this is His proper altar.'
He stood on one side of the furnace, she on the other; the
angry red coals glowed below, and a hot smoke rose from them.
She extended her hand to him, and he grasped it with the left
above the fire, and held the steel ring in his right.
 'Glory!' he said in a tremulous voice. 'At the altar in the church
you swore to obey me. In the hall you knelt and swore to cherish
me; here, over the fire, the figure of our God, as I put the iron ring
on, swear to me also to love me.'
She did not answer. She stood as though frozen to ice; with her
eyes on the door of the smithy, where stood a figure—the figure of a
man.
Suddenly she uttered a piercing cry. 'George! my George! my
George!' and withdrew her hand from the grasp of Elijah. The iron
ring fell from his fingers into the red fire below and was lost.

CHAPTER XXVII.
THE RETURN OF THE LOST.

Mehalah was clasped in the arms of George De Witt.

'Who is there? Where is he?' shouted Elijah, staggering forward
with his great pincers raised ready to strike.
George drew the girl out of the way, and let the angry man
burst out of the door and pass, beating the air with his iron tool. He
put his arm round her, and led her from the house. She could not
speak, she could only look up at him as at one risen from the dead.
He led her towards the sea-wall, looking behind him at the figure of
the blind man, rushing about, and smiting recklessly in his jealousy
and fury, and hitting bushes, rails, walls, anything in hopes of
smiting down the man whose name he had heard, and who he knew
had come back to break in on and ruin his hopes.
 George De Witt walked lamely, he had a somewhat stiff leg;
otherwise he seemed well.
'How manly you have grown!' exclaimed Mehalah, holding him
at arms' length, and contemplating him with pride.
'And you, Glory, have become more womanly; but in all else are
the same.'
'Where have you been, George?'
'At sea, Glory, and smelt powder. I have been a sailor in His
Majesty's Royal Navy, in the Duke of Clarence, and I am pensioned
off, because of my leg.'
'Have you been wounded?'
'Not exactly. A cannon-ball, as we were loading, struck me on
the shin and bruised the bone, so that I have been invalided with
swellings and ulcerations. I ain't fit for active service, but I'm not
exactly a cripple.'
'But George! when did this take place? I do not understand.
After your escape?'
'Escape, Glory? I have had no escape.'
'From confinement in Red Hall,' she added.
'I never was confined there. I do not know what you are talking
about.'
Mehalah passed her hand over her face.
'George! I thought that Elijah had made you drunk and then put
you in his cellar, chained there till you went mad.'
'There is not a word of truth in this,' said De Witt. 'Who told you
such a tale?'
'Elijah himself.'