“Each year in the US, corporations undertake over $500 billion in capital spending” (Bruner 184). This case provides well-analyzed teaching notes that describe how these financially sophisticated corporations calculate their capital costs. Comprehending the estimation of capital costs assists in recognizing the uncertainty of the cost-of-capital theory, establishes a standard for cost-of-capital, aids in determining the accuracy of cost estimations, and addresses the challenge of how a company truly determines its cost of capital.
When estimating capital costs, companies have the freedom to choose their own method. Research shows that approximately 93% of companies utilize a weighted-average cost-of-capital (WACC) in conjunction with discounting for their capital budgeting. Smaller companies often use a capital-asset pricing model (CAPM) in addition to WACC when determining the cost of equity. The following section will describe both methods and any variations that may exist between companies.
When calculating the Weighted Average Cost of Capital (WACC), corporations establish a standard to compare against other options in the capital market. Additionally, if a firm fails to exceed its cost-of-capital, it does not generate profit for investors since capital serves as an opportunity cost. The WACC model incorporates three variables: “K” indicates the component cost of capital, “W” denotes the weight of each component as a percentage of total capital, and “t” represents the marginal corporate tax rate. It is important to acknowledge certain methods and challenges when computing the WACC.
First, it is important to ensure that the costs are up to date and can be compared with the investors’ internal rate of return on future cash flows. Second, the weights used should reflect the current market rates, which is the common practice for most firms according to studies. Third, it is recommended to use the after-tax cost of debt in the calculation, which is typically based on marginal pretax costs and marginal tax rates. Additionally, determining the cost of equity capital poses a significant challenge when calculating the WACC.
The cost of equity cannot be estimated using observations or rates, so judgment and indirect methods are necessary. The most common method used to estimate the cost of equity is the Capital Asset Pricing Model (CAPM), although there are differences in its application. CAPM is a reliable estimation of the cost of equity. Three forward-looking variables are involved in calculating the cost of equity (Kequity): returns on risk-free bonds (Rf), the stock’s equity beta (? = 1, average risk), and the market risk premium (Rm – Rf). The rate of return on risk-free bonds (Rf) is usually determined by selecting a yield between the 90-day Treasury bill yield and the long-term Treasury bond yield. According to surveys, 70% of corporations and financial advisors use the Treasury bond yield with a maturity of 10 years or more. Estimates for the stock’s equity beta (?) are dependent on proxies as it measures the relative risk of an asset. Historical data, often from sources like Bloomberg, is used to estimate the beta.
The beta estimate is calculated using a formula that represents the beta as a slope coefficient of the market of returns, in addition to historical data. However, factors such as the number of time periods used, sample size, and choice of the market index all affect the determination of a satisfactory beta estimate. The market risk premium (Rm – Rf) is the final and most contentious factor in determining the cost of equity. The discrepancy primarily arises when calculating the average historical equity returns through either arithmetic or geometric methods.
When it comes to calculating equity returns, there are two commonly used approaches. The first approach is the arithmetic method, which involves averaging past returns. This method assumes that all returns are stable, evenly distributed, and independent across each time period. The second approach is the geometric method, which calculates the internal rate of return between a single outlay and future receipts. This compound rate represents an investor’s return over previous periods.
Although both approaches have their advantages, the arithmetic method is typically better for computing expected returns while the geometric method is more suitable for evaluating historical investment experiences.
It’s important to note that neither method is inherently superior to the other. However, when it comes to T-bills, the arithmetic mean return is more commonly used compared to the geometric mean.
While both approaches focus on past returns, the Capital Asset Pricing Model (CAPM) considers factors that look ahead into the future. This creates differences in defining a forward-looking variable that reflects the current market risk premium.
In addition to considering returns, risk plays a crucial role in calculating Weighted Average Cost of Capital (WACC).
When a company’s WACC can be used as a benchmark for its average risk investments, it is appropriate to use a single WACC. In order to obtain more capital, a premium payment based on risk is required. However, factors such as terminal values, synergies, and multidivisional companies can impact the discount rate for these risks. The case demonstrates that companies and financial advisors do consider these differences in risk, but they are addressed in various ways. Various methods and approaches are employed to manage risks.
Ideally, when valuing a synergy or investment opportunity, financial advisors recommend adjusting the cost of capital to reflect the risk of the project. However, according to the case, only 26% of companies actually make this adjustment, and a significant portion (one-third to one-half) fail to account for potential risk differences. Additionally, some advisors choose to adjust cash flows instead of discount rates. On the other hand, corporations face the challenge of deciding rate adjustments between divisions, leases, and investments, as they deal with centralized versus decentralized processes.
This leads to the adjustment of some risks using discount rates and others using internal methods. The case highlights the importance of accounting for risk, regardless of the approach taken. Advisors may choose not to adjust risk due to a lack of an objective financial market-rate benchmark, but risk adjustments will still be made, either by adjusting cash flows or relying on internal methods, although not necessarily in the WACC. Overall, the case aimed to identify the “best practice” for estimating the cost of capital. While each company has its own methods, there was a general consensus on the estimation of WACC. This paper details several key similarities in determining WACC, such as using market-value weight, after-tax cost of debt, and CAPM to calculate the cost of equity.
The CAPM focuses on factors such as beta, risk-free rate, and market risk premium. Beta is typically obtained from a published source and is based on a long interval of equity returns. The risk-free rate is determined by referring to the US government Treasury bond with a maturity of ten years or more. However, there is controversy surrounding the market risk premium due to different values and estimation methods being used. Moreover, the WACC should be adjusted for risk either directly or through another internal method. Despite some agreement among these methods, the case suggests that companies and advisors may be excessively adhering to finance theory.
Minute differences in beta, risk assessment, and estimation of the equity market risk premium can all have an impact on the result of the WACC. These implications are significant and can influence decision-making by managers who use the WACC for guidance in capital budgeting. It is advised to follow these “best practices” in determining WACC estimations, but it is also important not to solely rely on the figures, as there are certain factors that can affect the outcome.
