Estimating the Cost of Capital : Survey and Synthesis

Case 12

“Best Practices” in Estimating the Cost of Capital: Survey and Synthesis.

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. By the early 1990s, a consensus had emerged prompting such descriptions as “traditional… textbook…. appropriate,” “theoretically correct” and “a useful rule of thumb and a good vehicle.” Beneath this general agreement about cost of capital theory lies considerable ambiguity and confusion over how the theory can best be applied, The issues at stake are sufficiently important that differing choices on a few key elements can lead to wide disparities in estimated capital cost. The cost of capital is central to modern finance touching on investment and divestment decisions, measures of economic profit, performance appraisal and incentive systems. Each year in the United States, corporations undertake more than $500 billion in capital spending, Since a difference of a few percent in capital costs can mean a swing in billions of expenditures, how firms estimate the cost is no trivial matter.

The purpose of this paper is to present evidence on how some of the most financially sophisticated companies and financial advisers estimate capital costs. This evidence is valuable in several respects. First, it identifies the most important ambiguities in the application of cost-of-capital theory, setting the stage for productive debate and research on their resolution. Second, it helps interested companies benchmark their cost-of-capital estimation practices against best-practice peers. Third, the evidence sheds light on the accuracy with which capital costs can be reasonably estimated, enabling executives to use the estimates more wisely in their decision making. Fourth, it enables teachers to answer the inevitable question, “How do companies really estimate their cost of capital?”...