Do You Know Your Cost of Capital?

As per the estimation of the cost of equity, about 90% of the respondents use the capital asset
pricing model CAPM Portfolio Theory and the Capital Asset Pricing Model, which measures the
return required by an investment on the basis of the associated risk.
But that is where the consensus ends. Finance professionals differ in opinion on the underlying
assumptions for 6 basic metrics:

The Investment Time Horizon

The Cost of Debt
The Risk-Free Rate
The Equity Market Premium
The Risk of the Company Stock Beta
The Debt-to-Equity Ratio
Project Risk Adjustment

The Investment Time Horizon

The errors originate by the previous phases. As per the respondents there was 46 % assessment
about cash flows in the previous five years like for example the pharmaceutical company
estimates an investment in a drug over the expected life of the patent, whereas a software
producer uses a much shorter time horizon for its products. Whereas this limit varies according
to the companys project.

The Cost of Debt

As per the cost of debt the manager after analyzing the previous costs he should estimates his
discounted rate of investments, and this rate is comprised on the companys cost of capital,
which is the weighted average of the companys cost of debt and its cost of equity, the WACC
The procedure of assessing the cost of debt should be not difficult. But in general people find
many ways to calculate the tax that causes many difficulties in their cost of capital.
The Risk-Free Rate
Ambiguity arises only when most of the people start to calculate their cost but now most
managers start with the return that an equity investor would demand on a risk-free investment.
Mostly investors and analysts sets the standards of U.S. Treasury rates. But thats apparently all
they agree on.

46% of our survey participants use the 10-year rate,

12% go for the five-year rate,
11% prefer the 30-year bond
16% use the three-month rate.
The Equity Market Premium

Weighted-average cost of capital WACC is the risk premium for the company equity market
experience. The risk premium of the market should be the same at any given moment for all
investors.

The estimates, however, are varied.

About half the companies in the AFP survey use a risk premium between 5% and 6%
Some use one lower than 3%,
Others go with a premium greater than 7%

A wide range of more than 4 percentage points, we have found that companies tend to use a
standard, not a project-specific, time period. In theory, the problem can be mitigated by using the
appropriate terminal value the number ascribed to cash flows beyond the forecast horizon.
The Risk of the Company Stock
Calculating a companys cost of equity is the final stage to measure the Beta, a number that
reflects the volatility of the firms stock relative to the market. A Beta greater than 1.0 reflects a
company with greater-than-average volatility; a Beta less than 1.0 corresponds to below-average
volatility. Most financial executives understand the concept of Beta, but they cant agree on the
time period, over which it should be measured,

41% look at it over a five-year period

29% at one year
15% go for three years
13% for two.

Reflecting on the impact of the market meltdown in late 2008 and thecorresponding spike in vola
tility, you see that the measurement periodsignificantly influences the Beta calculation and, there
by, the final estimate of the cost of equity.
The Debt-to-Equity Ratio
Furthermore relative proportions of debt and equity that issuitable to investmentin a project. The
investors usually separated the following ratios:

Current book debt to equity (30% of respondents);

Targeted book debt to equity (28%)
Current market debt to equity (23%)
Current book debt to current market equity (19%).

 Project Risk Adjustment

The last thing is to analyze the WACC Approximately there werehalf of 70% who takes the risk
to achieve their projected targets of the company Many companies dont undertake any such
analysis instead they simply add a percentage point or more to the rate. An arbitrary adjustment
of this kind leaves these companies open to the peril of overinvesting in risky projects (if the
adjustment is not high enough) or of passing up good projects (if the adjustment is too high) 37%
of companies surveyed by the AFP made no adjustment at all: They used their companys own
cost of capital to quantify the potential returns on an acquisition or a project with a risk profile
different from that of their core business.