Case 13. Best Practices in
Estimating the Cost of Capital:
Survey and Synthesis
Goal:
• To learn how some of the most financially
sophisticated companies and financial
advisers estimate cost of capitals
I. The Weighted-Average Cost of Capital
WACC  (Wdebt (1  t )Kdebt )  (Wpreferred K preferred )  (WequityKequity )
• Minimum Cost
• Benchmark & Opportunity Costs
• Interesting Points:
To Reflect Market Costs & Weight
To Reflect Costs of Debts after Tax
• Problematic Cost of Equity
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
• 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
- 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
Rit  i  i ( Rm )
- 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
• 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.
• 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
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.
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.
• 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