Cost of Capital Estimation in the Current Distressed Environment

Abstract

The current economic environment has created challenges in estimating the cost of equity capital (“COEC”) and in estimating the appropriate overall cost of capital (i.e., the weighted average cost of capital or “WACC”). Since late 2008, new complications have arisen in estimating the cost of capital. Traditional methods typically employed in estimating the COEC and the WACC are subject to significant estimation and data input problems. This paper attempts to address some of these issues and offers some specific recommendations on dealing with these issues. First, U.S. Treasury bond (“T-bond”) yields, the typical benchmark used in either the Capital Asset Pricing Model (“CAPM”) or the Build-up methods of estimating COEC, were temporarily low for several months, resulting in unreasonably low estimates of COEC as of the important valuation date, December 31, 2008. In the past several weeks T-bond yields have returned to more normal levels. Second, the expected equity risk premium (“ERP”), the rate of return expected on a diversified portfolio of common stocks in excess of the rate of return on an investment in T-bonds, has likely increased as the broad stock market level has declined. Third, because the stock market correction has been heavily concentrated in the financial services sector and in highly leveraged companies, the commonly-employed methods we use for estimating betas, the risk measure in the traditional CAPM, are potentially flawed providing faulty estimates of risk for non-financial and companies with little debt. The result is that at the very time when one assumes a priori that estimates of COEC have increased, the methods we traditionally use to estimate the COEC are providing calculations that imply risk has declined. Fourth, current leverage ratios are likely not sustainable in the long-term for many companies and one needs to consider estimating cost of capital with expected changing capital structures. Fifth, because income subject to income taxes is and will continue to be less than zero for many companies, one cannot automatically use an after-tax cost of debt capital (i.e., multiply the interest rate by one minus the income tax rate) in calculating an appropriate WACC. Sixth, one must always test the resulting cost of capital estimates for reasonableness and not simply apply data or formulas by rote.

Keywords: Cost of Capital, Equity Risk Premium, Beta, Weighted Average cost of Capital

JEL Classification: M40, M41