Case 13. Best Practices in Estimating the Cost of Capital: Survey and Synthesis

1. Case 13. Best Practices in Estimating the Cost of Capital: Survey and Synthesis

2. Goal: • To learn how some of the most financially sophisticated companies and financial advisers estimate cost of capitals

3. I. The Weighted-Average Cost of Capital • Minimum Cost • Benchmark & Opportunity Costs • Interesting Points: To Reflect Market Costs & Weight To Reflect Costs of Debts after Tax • Problematic Cost of Equity

4. II. Survey Findings A. A sample of 27 firms B. Similarity • 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

5. CAPM is mainly used to calculate the cost of equity. Sometimes, a multifactor model is used. C. Disagreements from CAPM • How to apply CAPM to estimate cost of equity C-1. Risk free rate : between 90 day T-Bill and a long term treasury bond yield

6. - Strong preference on long term bond yield (10 years or more than) • Matching the terms of the risk free rate to the tenor of investment C-2. Beta Estimates with historical data

7. - Estimation periods - Market index including human capital and other non-traded assets - More than 40% of corporations and financial advisors simply use the published source for beta estimation C-3. Equity Market Risk Premium

8. To extrapolate historical returns into the future on the presumption that past experience heavily conditions future expectations. • Arithmetic Mean Return – simple average. • Geometric Mean Return – Internal rate of return, reflecting actual returns. • The geometric average is always less than the arithmetic average.

9. 71% support use of the arithmetic for the equity risk premium • Depending on the estimation periods, market risk premium ranges between 3 to 7.4% III. Risk Adjustments To WACC • WACC should be adjusted to deal with different levels of risks

10. Ex) multidivisional company or terminal values etc • All financial advisers are using different capital costs for valuating firm • Rather than adjusting discount rates, they adjust cash flows or multiples to deal with merger or realizations of synergies • Risk-adjusted discount rates are more likely used when the analyst can establish relatively objective financial market bench marks for what rate adjustments should be. Otherwise, they try to find other ways.

11. IV. Conclusions Best current practice in the estimation of WACC: • Weight should be based on the market value mixes of debt and equity • After-tax cost of debt • CAPM is currently the preferred model for estimating the cost of equity • Betas are drawn substantially from published sources.

12. Risk-free rate should match tenor of the cash flows being valued. • Equity market risk premium: best practical companies use 6 % or lower • Re-estimating WACC should be done at least annually • WACC should be readjusted to reflect different level of risk and other characters