Cost of Capital: Estimation and Applications

Cost of Capital......Page 3
About the Authors......Page 8
Contents......Page 11
List of Exhibits......Page 17
Foreword......Page 19
Preface......Page 21
Acknowledgments......Page 25
Introduction......Page 27
Notation System Used in This Book......Page 30
Part I. Cost of Capital Basics......Page 33
1. Defining Cost of Capital......Page 35
Components of a Company’s Capital Structure......Page 36
Cost of Capital Is Forward Looking......Page 37
Cost of Capital Equals Discount Rate......Page 38
Summary......Page 39
Net Cash Flow Is the Preferred Economic Income Measure......Page 41
Cost of Capital Is the Proper Discount Rate......Page 42
Example: Valuing a Bond......Page 43
Relationship of Discount Rate to Capitalization Rate......Page 44
Summary......Page 45
Defining Net Cash Flow......Page 47
Net Cash Flows Should Be Probability-Weighted Expected Values......Page 49
Why Net Cash Flow Is the Preferred Measure of Economic Income......Page 51
Summary......Page 52
4. Discounting versus Capitalizing......Page 53
Example: Valuing a Preferred Stock......Page 54
Functional Relationship between Discount Rate and Capitalization Rate......Page 55
Gordon Growth Model......Page 57
Combining Discounting and Capitalizing (Two-stage Model)......Page 58
Equivalency of Discounting and Capitalizing Models......Page 61
Midyear Convention......Page 62
Summary......Page 64
Defining Risk......Page 66
Types of Risk......Page 67
How Risk Impacts the Cost of Capital......Page 68
Summary......Page 69
6. Cost Components of a Company’s Capital Structure......Page 71
Debt......Page 72
Preferred Equity......Page 73
Common Stock or Partnership Interests......Page 74
Summary......Page 75
When to Use Weighted Average Cost of Capital......Page 77
Computing WACC for a Public Company......Page 78
Computing WACC for a Private Company......Page 80
Summary......Page 84
Part II. Estimating the Cost of Equity Capital......Page 87
8. Build-up Models......Page 89
Risk-free Rate......Page 90
Equity Risk Premium......Page 92
Small Stock Premium......Page 96
Company-specific Risk Premium......Page 97
Example of a Build-up Model......Page 99
Summary......Page 100
Concept of Systematic Risk......Page 102
Systematic and Unsystematic Risk......Page 103
Using Beta to Estimate Expected Rate of Return......Page 104
Expanding CAPM to Incorporate Size Premium and Specific Risk......Page 107
Expanded CAPM Cost of Capital Formula......Page 108
Assumptions Underlying the Capital Asset Pricing Model......Page 109
Recent Research on the Equity Risk Premium......Page 110
Summary......Page 111
Estimation of Beta......Page 112
Differences in Estimation of Beta......Page 114
Levered and Unlevered Betas......Page 115
Modified Betas: Shrunk and Lagged......Page 118
Summary......Page 119
Ibbotson Associates Studies......Page 122
Standard & Poor’s Corporate Value Consulting Studies (formerly the PricewaterhouseCoopers Studies)......Page 125
Extension of Data to Smaller Size Categories: Results from the Pratt’s Stats™ Database......Page 131
Summary......Page 139
Theory of the DCF Method......Page 141
Single-stage DCF Model......Page 142
Multistage DCF Models......Page 145
Summary......Page 147
13. Using Ibbotson Associates Cost of Capital Data......Page 148
Stocks, Bonds, Bills and Inflation......Page 149
Cost of Capital Yearbook......Page 160
Ibbotson Beta Book......Page 166
Cost of Capital Center......Page 171
Explanation of the APT Model......Page 175
APM Formula......Page 176
Summary......Page 179
Part III. Other Topics Related to Cost of Capital......Page 181
15. Minority versus Control Implications of Cost of Capital Data......Page 183
Minority versus Control Has Little or No Impact on Cost of Capital......Page 185
Company Efficiency versus Shareholder Exploitation......Page 186
Under What Circumstances Should a Control Premium Be Applied?......Page 187
A Tale of Two Markets......Page 188
Many Takeovers at Less Than Public Trading Price......Page 189
Summary......Page 195
Discrete Percentage Discount for Lack of Marketability......Page 197
Building the Discount for Lack of Marketability into the Discount Rate......Page 205
Summary......Page 206
17. How Cost of Capital Relates to the Excess Earnings Method of Valuation......Page 208
Basic “Excess Earnings” Valuation Method......Page 210
Cost of Capital Reasonableness Check......Page 212
Vagaries of the Excess Earnings Method......Page 214
Summary......Page 215
18. Common Errors in Estimation and Use of Cost of Capital......Page 216
Mistaking Historical Rates of Return for Expected Rates of Return......Page 217
Mismatching the Discount Rate with the Economic Income Measure......Page 218
Performing an Excess Earnings Method Valuation That Results in an Unrealistic Cost of Capital......Page 220
Projecting Growth beyond That Which the Capital Being Valued Will Support......Page 221
Incorrect or Inadequately Supported Data in Estimating the Cost of Equity......Page 222
Summary......Page 223
Cost of Capital in Shareholder Disputes......Page 225
Cost of Capital in the Tax Court......Page 226
Cost of Capital in Family Law......Page 229
Cost of Capital in Bankruptcy Reorganizations......Page 230
Cost of Capital Included in Damages......Page 234
Cost of Capital in Utility Rate-setting......Page 235
Taxicab Lease Rates......Page 236
Summary......Page 237
20. Cost of Capital in Ad Valorem Taxation......Page 239
Introduction to Ad Valorem Taxation......Page 240
General Categories of Legislative Constraints Where Adjustments to the Cost of Capital Are Necessary......Page 241
Different Types of Adjustments......Page 242
Other Adjustments to the Cost of Capital......Page 253
Summary......Page 255
Invest for Returns above Cost of Capital......Page 256
Adjusted Present Value Analysis......Page 257
Summary......Page 259
22. Central Role of Cost of Capital in Economic Value Added......Page 261
EVA Financial Management System......Page 264
EVA and the Corporate Reward System......Page 265
Summary......Page 269
Appendixes......Page 271
Appendix A Bibliography......Page 273
Appendix B Courses and Conferences......Page 284
Appendix C Data Resources......Page 286
Appendix D Developing Cost of Capital (Capitalization Rates and Discount Rates) Using ValuSource PRO Software......Page 296
Appendix E Iterative Process Using CAPM to Calculate the Cost of Equity Component of the Weighted Average Cost of Capital......Page 306
Appendix F International Glossary of Business Valuation Terms......Page 324
Appendix G Converting After-tax Discount Rates to Pretax Discount Rates......Page 332
CPE Self-study Examination......Page 335
Index......Page 346