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

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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 that are looking to develop new products, expand factories and install new information technologies must estimate the total investment required to fund these projects. In addition, they also need to decide whether the expected rate of return exceeds the cost of the capital. As a result, accurately measuring the cost of capital is a critical element in many business decisions.

Companies often have various types of capital that include differences in risk, and required rates of return. A standard means of expressing the cost of this capital is through a weighted average of the costs used for individual sources of capital, and this is typically referred to as the weighted average cost of capital (WACC). There are three components to WACC: debt, preferred stock and common equity. The formula used to determine the value for WACC is outlined below:

WACC = (% of debt) * (after tax cost of debt)
+ (% of preferred stock) * (cost of preferred stock)
+ (% of common equity) * (cost of common equity)
= wdrd(1-T) + wpsrps + wsrs

Although the equation for WACC is comprised of three components, this case study primarily focuses on the Capital Asset Pricing Model (CAPM) for estimating the cost of equity. The reasoning behind...
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