Case Best Practices in Estimating the

Study Cost of Capital: Survey and

#1 Synthesis

Overview This case study focuses on where financial theory ends and practical application of the weighted average cost of capital (WACC) begins. It presents evidence on how some of the most financially complex companies and financial advisors estimated capital costs and focuses on the gaps found between theory and application. The approach taken in the paper differed from their predecessors in several various respects. Prior published information was solely based on written, closed-end surveys sent to a large number of firms, without a focused topic. The study set out to see if financial theory, specifically cost-of-capital, The is truly ubiquitous in Cost true of business Capital applications. (WACC)

Weighted

Average

Companies that are looking to develop new products, expand factories and install new information technologies must estimate the total investment required to fund these projects. In addition, they also need to decide whether the expected rate of return exceeds the cost of the capital. As a result, accurately measuring the cost of capital is a critical element in many business decisions.

Companies often have various types of capital that include differences in risk, and required rates of return. A standard means of expressing the cost of this capital is through a weighted average of the costs used for individual sources of capital, and this is typically referred to as the weighted average cost of capital (WACC). There are three components to WACC: debt, preferred stock and common equity. The formula used to determine WACC + + = = (% (% the (% of of value of debt) for * stock) equity) + WACC (after * * is tax (cost (cost of of outlined cost of below: debt) stock) equity) wsrs

preferred common

preferred common +

wdrd(1-T)

wpsrps

Although the equation for WACC is comprised of three components, this case study primarily focuses on the Capital Asset Pricing Model (CAPM) for estimating the cost of equity. The reasoning behind this will be discussed in the next section below. The purpose of CAPM is to calculate the required rate of return on any asset, and can be expressed Ri = Rf + (Rm as: Rf)

The CAPM model also stipulates that the cost of equity for a company depends on three components the return on risk free bonds (Rf), the stocks equity beta (), and the market Variations components Risk risk Within of Free Rate premium the (Rm Components the of of Rf). CAPM CAPM. Return

Their survey results found that there were substantial variations with all three

In the risk-free rate of return, the choice of the risk-free rate can have an effect on the cost of equity. More specifically, the cost of a short-term stock is typically used to gauge a short-term risk free rate, and typically a long-term stock is used to measure a longterm risk free rate. Since corporate projects are usually long-term projects, companies have a preference in using long-term bond yields. Beta

For beta, there are mainly two different ways to calculate the value for beta. The first is to calculate it yourself based on historical data. By using this method, you run the risk of using inaccurate data if you choose a period that is too broad or narrow. Conversely, the other way to determine it is to use published sources such as Bloomberg and Standard & Poors. Similar to using historical data to determine beta, there are variations in these published sources for the values of beta. As a result, the calculation of the overall cost of capital will vary depending Market on which source of Risk beta you choose to use.

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. Because the expected future returns are unobservable, every company used historical returns to help estimate future expectations. Specifically, there was a sizable difference between the use of arithmetic and geometric averages. Unless the returns are the same each time period, the geometric average will always be less than the arithmetic average. As a result, the gap between them will vary as the returns become unstable. 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. The results of the case study survey yielded that only 26% of companies always adjust the cost of capital to reflect investment opportunities, while the majority continued to use a stale value that may not have been appropriate to reflect investment opportunities.

Conclusions In a world where financial theory can only take you so far, financial companies have to identify a best practice policy when it comes to the grey area of cost-of-capital. This case study reveals that within the weighted average cost of capital, the main area of disagreement was in the details of executing CAPM to estimate the cost of equity. In an attempt to correct the inconsistencies with determining what values to use within the CAPM equation, the case study outlined various elements that represent best current practices The weights in should be the based or the preferred model on estimation market-value statutory for estimating mixes of of debt tax the cost of and WACC: equity rates equity

The after-tax cost of debt should be estimated from marginal pretax costs, combined with CAPM is marginal currently

Betas are drawn substantially from published sources, preferring those betas using a long interval of equity returns. Where a number of statistical publishers disagree, best practice often involves judgment to estimate a beta. Risk-free rate should match the tenor of the cash flows being values. For most capital projects and corporate acquisitions, the yield on the US government Treasury bond of ten or more years in maturity would be appropriate. Choice of an equity market risk premium is the subject of considerable controversy both as to its value and method of estimation. The majority of the best-practice companies surveyed used a premium of 6% or lower, while many texts and financial advisers use higher figures. Monitoring for changes in WACC should be keyed to major changes in financial market conditions, but should be done at least annually. Actually flowing a change through a corporate system of project valuation and compensation targets must be done gingerly and only when there are material changes. WACC should be risk adjusted to reflect substantive differences among different businesses in a corporation. Corporations also cite the need to adjust capital costs across national boundaries. In situations where market proxies for a particular type of risk class are not available, best practice involves finding other means to account for risk differences. Although best practice is typically consistent with finance theory, problems in application arise due to a divergence in estimated capital costs. Even though the calculated rate determined by the WACC can vary significantly depending on what values are used, it is still a useful measure that a firm can use to value the costs of projects and should not be immediately dismissed. As a result, financial advisors need to take the time to choose the appropriate method of valuation to ensure a precise rate for the WACC. This is critical because if the WACC is inaccurate, a financial manager may decide to pass on a potential project that could realistically provide additional revenue for the company.