Case 13

Survey Questions

Conclusions

Risk adjustments to WACC

• Weights

• Cost of debt

• CAPM

• Betas

• Risk-free rate

• Choice of equity market risk premium

• Monitoring for changes in WACC

• WACC adjustment

Key Takeaways

• Additional tools needed

• Lack of good market data

• Further research needed

• Accuracies in estimating WACC

• Estimating is better than nothing

• Financial theory

• Financial advisers and discount rates

• Cost of capital adjustment

• Gitman and Mercurio 1982

• Trade books and textbooks

• Financial market data vs. managerial judgments

Risk adjusted discount rates vs. cash flow adjustments

• Risk adjusted discount rates

• What happens when there are no available benchmarks?

• Where corporations look for risk and data comparisons

Case 13

Financial advisers and differing capital cost usage

• Over 50% have select different rates

• 10% use different discount rates

• 2 reasons

Real responses from investment banks reveal another story

• “We make these adjustments in cash flows & multiples rather than discount rates”

• “Risk factors may be different for realizations of synergies, but we make adjustments to cash flows rather than the discount rate.”

What Corporations Face

• WACC calculations and appraisals of specific projects

• Blended approaches for dealing with risk

• Divisional capital costs, investments and leasing/non leasing

• Respondents favored cash flow adjustments in dealing with risks

How often do companies re-estimate capital costs?

• Changes have to be significant

• Firms are willing to live with approximations

• Capital costs are estimated not final word

• Size of risk, quality of information and administrative cost

Best Practices in Estimating the

Cost of Capital:Survey and Synthesis

Evidence is Valuable because:

The WACC

Introduction

• Doubts in Capital Theory
• Benchmarks from company to company
• Using estimates more wisely in decision making
• How do companies really estimate their cost of capital

Corporate uses of capital must be benchmarked against market alternatives. The cost of capital provides the benchmark

• Survey on how most important companies and financial advisors estimate capital costs

• Where is Financial Theory silent

Survey Findings

Nancy Alvarez

Glenn McWherter

• Discounted Cash Flows is dominant investment evaluation
• WACC is dominant Discount rate
• After tax cost of debt based on marginal pretax costs
• CAPM is dominant Model

Previous Research

Beta

Survey Results

Historical Data

Increasing number of time periods

Shortening observation period

Market Index

50% of Corporations rely on publish results from Bloomberg, Value Line, and Standard & Poors

30% Calculate their own

40% Financial Advisors rely on publised Betas

20% Calculate thier own

40% Use Fundamental Betas

• 1977-IRR and PayBack Period were common

• Multiple Choice, fill in the blank surveys

Companies in Research

CAPM

WACC

CAPM

Survey Questions

90 day T-Bill or Long Term Bond?

Companies said they would match

the average investment horizon

with maturity of debt.

In Finance Theory

1.Capital Cost Should be Current

2. Should equal IRR on future Cash Flows

3.Market Weights

4. Cost of debt after tax

Impact of various assumptions for using CAPM

• Black & Decker vs. McDonalds

• Derivation of WACC for respondents

• 3 approaches

• Ranges for each firm

• Reasons for variation

Texts and trade books in the survey

• Preferences

• Ehrhardt study of 1994

• Kaplan and Ruback

1995 study

Preferences

• Financial advisers and equity risk premium preferred

• Corporate favored lower premiums

• Diversity among survey participants

• Take away from the survey

Arithmetic mean return

• Defined

• Arithmetic mean return is best

Geometric mean return

• Defined

• Accurate predictor of historical

investment experience

• Geometric average returns will be

less than Arithmetic average

Equity market risk premium

Exhibit 7

• Historical differences in market risk premiums

• Differences in T-bills for arithmetic mean vs. geometric mean

• Variations for market risk premiums

• How historical market premiums have changed over time

• Defined as excess returns expected by investors relative to riskless assets

• Respondents extrapolated historical into the future

• Differing respondent usage of historical equity returns

• Usage for risk-free rate