Estimation of the Cost of Capital:

In recent decades, theoretical breakthroughs in such areas as portfolio diversification, market efficiency, and asset pricing have converged into compelling recommendations about the cost of capital to a corporation. The cost of capital is central to modern finance, touching on investment and divestment decisions, measure of economic profit, performance appraisal, and incentive systems.

Each year in the United States, corporations undertake more than $500 billion in expenditures, so how firms estimate the cost is not a trivial matter. A key insight from finance theory is that any use of capital imposes an opportunity cost on investors; namely, funds are diverted from earning a return on the next-best equal risk investment. Since investors have access to a host of financial market opportunities, corporate use of capital must be benchmarked against these capital market alternatives. The cost of capital provides this benchmark. Unless a firm can earn in excess of its cost of capital, it will not create economic profit or value for investors. A recent survey of leading practitioners reported the following best practices:

  1. Discounted cash flow (DCF) is the dominant investment-evaluation technique.
  2. Weighted average cost of capital (WACC) is the dominant discount rate used in DCF analyzes.
  3. Weights are based on market, not book, value mixes of debt and equity.
  4. The after-tax cost of debt is predominantly based on marginal pretax costs, as well as marginal or statutory tax rates.
  5. The capital asset pricing model (CAPM) is the dominant model for estimating the cost of equity.

Discounted cash flow valuation models

The parameters that make up the DCF model are related to risk (the required rate of return) and the return itself. These models use three alternative cash-flow measures: dividends, accounting earnings, and free cash flows. Just as DCF and asset-based valuation models are equivalent under the assumption of perfect markets, dividends, earnings, and free cash-flow measures can be shown to yield equivalent results. Their implementation, however, is not straightforward. First, there is inherent difficulty in defining the cash flows used in these models. Which cash flows and to whom do they flow? Conceptually, cash flows are defined differently depending on whether the valuation objective is the firm’s equity or the value of the firm’s debt plus equity. Assuming that we can define cash flows, we are left with another issue. The models need future cash flows as inputs. How is the cash-flow stream estimated from present data? More important, are current and past dividends, earnings, or cash flows the best indicators of that stream? These pragmatic issues determine which model should be used. Although the dividend model is easy to use, it presents a conceptual dilemma. Finance theory says that dividend policy is irrelevant. The model, however, requires forecasting dividends to infinity or making terminal value assumptions. Firms that presently do not pay dividends are a case in point. Such firms are not valueless. In fact, high-growth firms often pay no dividends, since they reinvest all funds available to them. When firm value is estimated using a dividend discount model, it depends on the dividend level of the firm after its growth stabilizes. Future dividends depend on the earnings stream the firm will be able to generate. Thus, the firm’s expected future earnings are fundamental to such a valuation. Similarly, for a firm paying dividends, the level of dividends may be a discretionary choice of management that is restricted by available earnings. When dividends are not paid out, value accumulates within the firm in the form of reinvested earnings. Alternatively, firms sometimes pay dividends right up to bankruptcy. Thus, dividends may say more about the allocation of earnings to different claimants than valuation. All three DCF approaches rely on a measure of cash flows to the suppliers of capital (debt and equity) to the firm. They differ only in the choice of measurement, with the dividend approach measuring the cash flows directly and the others arriving at them in an indirect manner. The free cash-flow approach arrives at the cash-flow measure (if the firm is all-equity) by subtracting investment from operating cash flows, whereas the earnings approach expresses dividends indirectly as a fraction of earnings.

The capital asset pricing model

This is a set of predictions concerning equilibrium expected returns on risky assets. Harry Markowitz established the foundation of modern portfolio theory in 1952. The CAPM was developed twelve years later in articles by William Sharpe, John Lintner, and Jan Mossin. Almost always referred to as CAPM, it is a centerpiece of modern financial economics. The model gives us a precise prediction of the relationship that we should observe between the risk of an asset and its expected return. This relationship serves two vital functions. First, it provides a benchmark rate of return for evaluating possible investments. For example, if we are analyzing securities, we might be interested in whether the expected return we forecast for a stock is more or less than its “fair” return given its risk. Second, the model helps us to make an educated guess as to the expected return on assets that have not yet been traded in the marketplace. For example, how do we price an initial public offering of stock? How will a new investment project affect the return investors require on a company’s stock? Although the CAPM does not fully withstand empirical tests, it is widely used because of the insight it offers and because its accuracy suffices for many important applications. Although the CAPM is a quite complex model, it can be reduced to five simple ideas:

  1. Investors can eliminate some risk (unsystematic risk) by diversifying across many regions and sectors.
  2. Some risk (systematic risk), such as that of global recession, cannot be eliminated through diversification. So even a basket with all of the stocks in the stock market will still be risky.
  3. People must be rewarded for investing in such a risky basket by earning returns above those that they can get on safer assets.
  4. The rewards on a specific investment depend only on the extent to which it affects the market basket’s risk.
  5. Conveniently, that contribution to the market basket’s risk can be captured by a single measure—”beta”—that expresses the relationship between the investment’s risk and the market’s risk.

Finance theory is evolving in response to innovative products and strategies devised in the financial market-place and in academic research centers.