Case 13: Best Practices in Estimating the Cost of Capital - Survey and Synthesis.docx

Unformatted text preview: Ely Garcia 10/7/17 FINC-4349-01 Best Practices In Estimating The Cost Of Capital: Survey & Synthesis Case Summary This case utilizes cost-of-capital surveys taken from 27 well-respected corporations to understand how they successfully and efficiently estimate the cost of capital. The results for such surveys illustrated common theoretical frameworks and many aspects of estimation aligned among these well-established corporations. Where they found the most variation in this case was in the join choices of the risk-free rate, beta, and the equity market risk premium, as well as for the adjustment of capital costs for specific investment risk. Main Problem This case has proven that measuring the cost of capital is a crucial element and is often neglected in business, which eventually makes them unsuccessful in estimating the costs. Mistakes like that cause severe damages to the growth of the business, so this case explains how that can be avoided and better suit common theoretical frameworks. Furthermore, the main problem in solving for WACC is coming up with a cost of equity capital. There are no observations or rates that can be used to estimate the cost of equity; that said, judgment and indirect methods must be used to determine this cost. From the surveys in the case, the CAPM is most often used to estimate the cost of equity; however, differences regarding the application of this model are clearly noted. Analysis A few of the main similarities regarding the WACC include the use of a market-value weight, after-tax cost of debt, and the CAPM to determine the cost of equity. Regarding the CAPM, the beta is usually drawn from a published source and uses a long interval of equity returns. Finance theory calls for a forward-looking beta, one reflecting investor’s uncertainty about the future cash flows to equity. Over half of the corporations in the survey relied on published sources for their beta estimates. Among financial advisers, 40% rely on published sources, 20% calculated their own, and another 40% use what could be called “fundamental” beta estimates. The risk-free rate is based on the US government Treasury bond of ten or more years to maturity and the market risk premium is the most controversial variable with different values and methods of estimations being used. Choice of a risk free rate can have a material effect on the cost of equity and WACC. Long term bond yields more closely reflecting default free holding period returns available on long lived investments and so it is more coherent with the types of investments made by companies. The survey results in the case revealed a strong preference for long term bond yields, defends the argument that a lot of the corporations matched the term of risk free rate to the tenor of the investment. Last, the WACC should be risk adjusted whether it is done by adjusting the WACC or some other internal method. When asked about risk adjustment, these firms responded as follows: “we make these adjustments in cash flow rather than in discount rates”, “risk factor may be different for realization of synergies, but we make adjustment to cash flow rather than the discount rates”. The survey also revealed broad acceptance of the WACC as the basis for setting discount rates. WACC: E/V*Re + D/V*Rd*(1-Tc) CAPM: rf + Ba(rm-rf) Although these methods are in broad agreement, the case proclaims that maybe companies and advisors are being too consistent with the finance theory. Small difference in beta, the assessment of risk, and the estimation equity market risk premium can all affect the outcome of the WACC. These important implications can affect how managers make decisions when they are looking at the WACC for guidance in capital budgeting. Conclusion After describing the two methods of estimating the cost of capital, we can see many differences in practice. The purpose of the case is to find a “best practice” for estimating the cost of capital. All companies have their own methods, but there proved to be a general consensus on the estimation of WACC. Furthermore, the conclusion of the case is to follow these “best practices” as guidance in determining the WACC estimates; however, we can’t rely completely on the figures, for there are certain implications that can affect the outcome. ...
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