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

1254 Words Apr 30th, 2012 6 Pages
Overview
This case study focuses on where financial theory ends and practical application of the weighted average cost of capital (WACC) begins. It presents evidence on how some of the most financially complex companies and financial advisors estimated capital costs and focuses on the gaps found between theory and application. The approach taken in the paper differed from their predecessors in several various respects. Prior published information was solely based on written, closed-end surveys sent to a large number of firms, without a focused topic. The study set out to see if financial theory, specifically cost-of-capital, is truly ubiquitous in true business applications.

The Weighted Average Cost of Capital (WACC)
Companies
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Because the expected future returns are unobservable, every company used historical returns to help estimate future expectations. Specifically, there was a sizable difference between the use of arithmetic and geometric averages. Unless the returns are the same each time period, the geometric average will always be less than the arithmetic average. As a result, the gap between them will vary as the returns become unstable.

Risk Adjustments to WACC
The use of WACC is useful if it is for investments of broad and average comparable risk. However, it is not suitable for individual risk. The results of the case study survey yielded that only 26% of companies always adjust the cost of capital to reflect investment opportunities, while the majority continued to use a “stale” value that may not have been appropriate to reflect investment opportunities.

Conclusions
In a world where financial theory can only take you so far, financial companies have to identify a “best practice” policy when it comes to the grey area of cost-of-capital. This case study reveals that within the weighted average cost of capital, the main area of disagreement was in the details of executing CAPM to estimate the cost of equity. In an attempt to correct the inconsistencies with determining what values to use within the CAPM equation, the case study outlined various elements

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