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best practices in estimating the cost of capital

“Each year in the US, corporations undertake more than $500 billion in capital spending” (Bruner 184). This case presents a reasonably analyzed set of teaching notes describing how these financially sophisticated corporations estimate their capital costs. Understanding the estimation of capital costs helps identify the uncertainty of the cost-of-capital theory, sets a benchmark for cost-of-capital, helps determine the accuracy of estimating costs, and solves the problem of how a company really estimates their cost of capital.

When dealing with the estimation of capital costs, companies are left to their own discretion on how to estimate such a cost. Surveys conclude that about 93% of companies us a weighted-average cost-of-capital along with some sort of discounting in their capital budgeting. Smaller companies tend to use a capital-asset pricing model (CAPM) along with the WACC when estimating the cost of equity. Both of the methods, along with firm-to-firm discrepancies, will be described below. Weighted-Average Cost of Capital

With the WACC, corporations develop a standard to use against capital market alternatives. Moreover, since capital is an opportunity cost for investors, if a firm does not earn more than its cost-of-capital, it does not make money for the investors. The three variables used in a WACC model are “K” representing the component cost of capital, “W” representing the weight of each component as a percent of total capital, and “t” representing the marginal corporate tax rate. When calculating the WACC, there are certain methods and difficulties that are worth noting.

First, the costs should always be current and comparable to the investors’ internal rate of return on future cash flows. Second, the weights used should always be the current market rates, which studies found is the popular practice for most firms. Third, the after-tax cost of debt should be used in the formulation, which studies found was usually based on marginal pretax costs and marginal tax rates. Furthermore, the primary difficulty in solving for WACC is coming up with a cost of equity capital.

There are no observations or rates that can be used to estimate the cost of equity; therefore, judgment and indirect methods must be used to determine this cost. From the surveys in the case, the CAPM is most often used to estimate the cost of equity; however, differences regarding the application of this model are present. Capital Asset Pricing Model CAPM is a good estimation of the cost of equity. When computing the cost of equity, Kequity, three forward-looking variables are involved including the returns on risk-free bonds (Rf), the stock’s equity beta (? = 1. average risk), and the market risk premium (Rm – Rf). The rate of return on the risk-free bonds (Rf) is commonly derived by choosing a yield between the 90-day Treasury bill yield and the long-term Treasury bond yield. With that being said, surveys show that 70% of corporations and financial advisors use the Treasury bond yield with a maturity of 10 or more years. As for the stock’s equity beta (?), which measures the relative risk of an asset, estimates are dependent on proxies. To calculate a beta, historical data, usually from a published source such as Bloomberg, helps estimate the beta.

Along with the historical data, a formula depicting the beta as a slope coefficient of the market of returns is used to calculate the beta estimate. However, compromises including the number of time periods used, the sample size, and the choice of the market index, are all factors in determining a sufficient beta estimate. The last and most controversial variable of determining the cost of equity is the market risk premium (Rm – Rf). The main discrepancies arise when computing the average historical equity returns (arithmetic or geometric).

To further inquire, when arithmetically computing the equity returns, an average of past returns is used with the assumption that all returns are stable, evenly distributed, and independent through each period. On the other hand, when geometrically computing the equity returns, an internal rate of return is calculated between a single outlay and future receipts. This compound rate is used to portray an investor’s return over past periods. With that being said, an arithmetic approach tends to work best or computing the expected returns, while the geometric approach works best for outlaying a historical investment experience. Additionally, neither method is necessarily better than the other, but the arithmetic mean return over T-bills tends to be used more often than the geometric mean. However, both approaches are still focusing on past returns, while the CAPM method calls for forward-looking variables. The differences arise when defining a forward-looking variable that reflects the current market risk premium. Risk Adjustments to WACC Risk is another important factor of the WACC.

Only when a company’s WACC can be used as a benchmark for a firm’s average risk investments should a single WACC be used. Additionally, to acquire more capital, a payment of premium, which depends on risk, must be made. However, situations such as terminal values, synergies, and multidivisional companies can affect the discount rate of these risks. The case shows that companies and financial advisors do account for these risk differences, but are accounted for in a multitude of ways. Different methods and applications are used to deal with risks.

Ideally with financial advisors, when valuing a synergy or investment opportunity, a company should always adjust the cost of capital to reflect the risk of that project; however, the case proclaims that only 26% of companies adjust the cost of capital and one-third to one-half to do not account for the potential risk differences. Also, sometimes advisors adjust cash flows rather than adjusting the discount rates. As for corporations, they must deal with centralized versus decentralized processes, and must determine rate adjustments between divisions, leases, and investments.

This leads to some risks being adjusted using discount rates and other risks being adjusted using internal methods. The case points out that, one way or another, risk is accounted for. Advisors may not adjust the risk due to a lack of an objective financial market-rate benchmark; however, whether it’s adjusting cash flows or relying on internal focus, the risk adjustments will be accounted for, just maybe not in the WACC. Summary and Conclusions After describing the two pertinent methods of estimating the cost of capital nd the cost of equity, one can see the many differences in practices that arise. The purpose of the case was to find a “best practice” for determining the cost of capital estimation. 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, described in detail in this paper, 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.

Minute differences 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.

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