'Best Practices' in Estimating the Cost of Capital: An Update
Journal of Applied Finance, Spring/Summer 2013, Volume 23, No. 1
Posted: 16 Jul 2013
Date Written: July 15, 2013
Theories on cost of capital have been around for decades. Unfortunately for practice, the academic discussions typically stop at a high level of generality, leaving important questions for application unanswered. Recent upheavals in financial markets have only made the practitioner’s task more difficult. This paper updates our earlier work on the state of the art in cost of capital estimation to identify current best practices that emerge. Unlike many broadly distributed multiple choice or fill-in-the-blank surveys, our findings are based on conversations with practitioners at highly regarded corporations and leading financial advisors. We also report on advice from best-selling textbooks and trade books. We find close alignment among all these groups on use of common theoretical frameworks to estimate the cost of capital and on many aspects of estimation. We find large variation, however, for the joint choices of the risk-free rate of return, beta and the equity market risk premium, as well as for the adjustment of capital costs for specific investment risk. When compared to our 1998 publication, we find that practice has changed some since the late 1990s but there is still no consensus on important practical issues. The paper ends with a synthesis of messages from best practice companies and financial advisers and our conclusions.
Keywords: cost of capital, risk free rate, beta, equity market, merket risk premium
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