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Best Practices in Estimating the Cost of Capital: Survey and
Transcript of Best Practices in Estimating the Cost of Capital: Survey and
A sample of 27 firms
Discounted cash flow (DCF) is the dominant investment-evaluation technique
WACC is the dominant discount rate
Weights are based on market value, not book
The after-tax cost of debt
Risk Adjustments to WACC
The use of WACC is useful if it is for investments of broad and average comparable risk. However, it is not suitable for individual risk.
continued to use a “stale” value that may not have been appropriate to reflect investment opportunities.
Calculate it yourself based on historical data
To learn how some of the most financially sophisticated companies and financial advisers estimate cost of capitals
Variations Within the Components of CAPM
1. Risk free rate of return
3. Market risk premium
Best Practices in Estimating the Cost of Capital: Survey and Synthesis
The Weighted Average Cost of Capital (WACC)
looking to develop new products
install new information technologies
measuring the cost of capital is a critical element
Capital Asset Pricing Model
The purpose of CAPM is to calculate the required rate of return on any asset
the return on risk free bonds (Rf), the stock’s equity beta (β), and the market risk premium (Rm – Rf).
Risk free rate of return
In the risk-free rate of return, the choice of the risk-free rate can have an effect on the cost of equity.
Equity Market Risk Premium
For the market risk premium, the problem areas for the market risk premium are how a company measures the expected future returns on the market portfolio and on riskless assets.
Use published sources such as Bloomberg, Value Line and Standard & Poor’s
After describing the two methods of estimating the cost of capital, we can see many differences in practice. The purpose of the case is to find a “best practice” for estimating the cost of capital. All companies have their own methods, but there proved to be a general consensus on the estimation of WACC.
A few of the main similarities regarding the WACC include the use of a market-value weight, after-tax cost of debt, and the CAPM to determine the cost of equity. Regarding the CAPM, the beta is usually drawn from a published source and uses a long interval of equity returns; likewise, the risk-free rate is based on the US government Treasury bond of ten or more years to maturity and the market risk premium is the most controversial variable with different values and methods of estimations being used. Last, the WACC should be risk adjusted whether it is done by adjusting the WACC or some other internal method.
Although these methods are in broad agreement, the case proclaims that maybe companies and advisors are being too consistent with the finance theory. Small difference in beta, the assessment of risk, and the estimation equity market risk premium can all affect the outcome of the WACC. These important implications can affect how managers make decisions when they are looking at the WACC for guidance in capital budgeting. Furthermore, the conclusion of the case is to follow these “best practices” as guidance in determining the WACC estimations; however, do not rely completely on the figures, for there are certain implications that can affect the outcome.