Case 13 - Best Practices in Estimating the Cost of Capital
Best Practices in Estimating the Cost of Capital: Survey and Synthesis
Case 13
Teaching Notes
Introduction
“Each year in the US, corporations undertake more than $500 billion in capital spending” (Bruner 184). This case presents a reasonably analyzed set of teaching notes describing how these financially sophisticated corporations estimate their capital costs. Understanding the estimation of capital costs helps identify the uncertainty of the cost-of-capital theory, sets a benchmark for cost-of-capital, helps determine the accuracy of estimating costs, and solves the problem of how a company really estimates their cost of capital.
When dealing with the estimation of capital costs, companies are left to their own discretion on how to estimate such a cost. Surveys conclude that about 93% of companies us a weighted-average cost-of-capital along with some sort of discounting in their capital budgeting. Smaller companies tend to use a capital-asset pricing model (CAPM) along with the WACC when estimating the cost of equity. Both of the methods, along with firm-to-firm discrepancies, will be described below.
Weighted-Average Cost of Capital With the WACC, corporations develop a standard to use against capital market alternatives. Moreover, since capital is an opportunity cost for investors, if a firm does not earn more than its cost-of-capital, it does not make money for the investors. The three variables used in a WACC model are “K” representing the component cost of capital, “W” representing the weight of each component as a percent of total capital, and “t” representing the marginal corporate tax rate. When calculating the WACC, there are certain methods and difficulties that are worth noting. First, the costs should always be current and comparable to the investors’ internal rate of return on future cash flows. Second, the weights used should always be the current market rates, which studies found is the popular practice for most firms. Third, the
Case 13
Teaching Notes
Introduction
“Each year in the US, corporations undertake more than $500 billion in capital spending” (Bruner 184). This case presents a reasonably analyzed set of teaching notes describing how these financially sophisticated corporations estimate their capital costs. Understanding the estimation of capital costs helps identify the uncertainty of the cost-of-capital theory, sets a benchmark for cost-of-capital, helps determine the accuracy of estimating costs, and solves the problem of how a company really estimates their cost of capital.
When dealing with the estimation of capital costs, companies are left to their own discretion on how to estimate such a cost. Surveys conclude that about 93% of companies us a weighted-average cost-of-capital along with some sort of discounting in their capital budgeting. Smaller companies tend to use a capital-asset pricing model (CAPM) along with the WACC when estimating the cost of equity. Both of the methods, along with firm-to-firm discrepancies, will be described below.
Weighted-Average Cost of Capital With the WACC, corporations develop a standard to use against capital market alternatives. Moreover, since capital is an opportunity cost for investors, if a firm does not earn more than its cost-of-capital, it does not make money for the investors. The three variables used in a WACC model are “K” representing the component cost of capital, “W” representing the weight of each component as a percent of total capital, and “t” representing the marginal corporate tax rate. When calculating the WACC, there are certain methods and difficulties that are worth noting. First, the costs should always be current and comparable to the investors’ internal rate of return on future cash flows. Second, the weights used should always be the current market rates, which studies found is the popular practice for most firms. Third, the