Business Valuation & Cost of Capital

TIMOTHY A. LUEHRMAN

Business Valuation and the Cost of Capital

A common approach to valuing a business is to discount its expected future cash flows at its cost of capital. This note explains how to compute the cost of capital for such an analysis. It consists of three sections: the first is focused on the financial economics of the problem; the second on practical considerations related to calculations; and the third concludes with some cautionary advice.

Having defined the cost of capital as an opportunity cost, we may now note that it is not necessarily the same as a treasurer’s “all-in cost of funds” used for comparing alternative funding sources. For example, suppose an investment project’s opportunity cost of funds is 10%, but the corporate treasurer has found a bargain and can actually raise the needed funds at a cost of 8%. Which should be used as a discount rate? The correct discount rate is still 10%. If we discount the project’s cash flows at 8%, we will over-value it compared to alternative investments. If we overvalue it, we may over-pay for it compared to alternative investments, which would not be valuemaximizing. The fact that the treasurer can raise cheaper funds is indeed valuable, but the difference between 8% and 10% represents value created by skillful treasury operations, not by the investment project. The two should not be confused. A further implication of defining the cost of capital as an opportunity cost is that therefore capital markets matter, always. Not because the treasurer uses them to source new funding – some firms are self-financing and seldom if ever raise new external capital. Rather, it is because the capital markets are where we find the “alternative investment with identical risk.” The capital markets represent, in large part, investors’ opportunity set for competing investments. This is so even if a corporation is private rather than public, even if it is self-financing, and even if managers and/or investors...