Paraphrasing

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

1. Purpose of Article:

The purpose of this paper is present evidence on how some of the most financially sophisticated companies and financial advisers estimate capital cost.

1. Scope of the Article:

The article begins explaining some theoretical breakthroughs in the world of finance; however, the article explains there still is some ambiguity when it comes to implementing the cost of capital theory. Secondly, the article demonstrates how to benchmark cost of capital estimation practices. Thirdly, the author validates the accuracy with which capital costs can be reasonably estimated, which assists executives to use estimates more intelligently in their decision making. Finally, it answers the question: How do companies really estimate their cost of capital ?

1. Classification of the article:

Empirical.

1. Finding:

• DCF is the dominant investment-evaluation technique.

• WACC is the dominant discount rate used in DCF analyses.

• Weights are based on the market and not book values.

• The after tax cost of debt is predominantly based on marginal pretax costs.

• The CAPM is the dominant model for estimating the cost of equity.

When Choosing the risk-free rate of return it does matter what period one chooses as a treasury because the difference between realized returns on a 90 day T-bill and a ten year T-bill has averaged 150 basis points. Those findings prove that the choice of a risk free rate can have a notable effect on the cost of equity and WACC.

When it comes to Beta, finance theory calls for a forward looking one. One that reflects investors’ uncertainty about the future of cash flows to equity. Most often pro-forma betas are completed using beta estimates derived from historical date and published by such sources as Bloomberg, value line, and S&P.

Another way to calculate a future beta would be to use this equation:

R it = i +i (R mt)

Where:

R it= return on stock i in time period.

i= regression constant for stock i.

i= Beta for stck i.

R mt= return on the market portfolio in period i.

Beta providers use a variety of stock market indices as proxies for the market portfolio on the argument that stock markets trade claims on a sufficiently wide array of assets to be adequate replacements for the unobservable market portfolio.