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'Best Practices' in Estimating the Cost of Capital: An Update

19 Pages Posted: 12 Nov 2015  

W. Todd Brotherson

Southern Virginia University

Kenneth M. Eades

University of Virginia - Darden School of Business

Robert S. Harris

University of Virginia - Darden School of Business

Robert C. Higgins

University of Washington - Department of Finance and Business Economics

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Date Written: November 5, 2015

Abstract

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 advisors and our conclusions.

Suggested Citation

Brotherson, W. Todd and Eades, Kenneth M. and Harris, Robert S. and Higgins, Robert C., 'Best Practices' in Estimating the Cost of Capital: An Update (November 5, 2015). Journal of Applied Finance (Formerly Financial Practice and Education), Vol. 23, No. 1, 2013. Available at SSRN: https://ssrn.com/abstract=2686738

W. Todd Brotherson

Southern Virginia University ( email )

One University Hill Drive
Buena Vista, VA 24416
United States
(540) 261-8539 (Phone)
(540) 266-3859 (Fax)

Kenneth M. Eades

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4825 (Phone)
434-924-0714 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/eades.htm

Robert S. Harris (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4823 (Phone)
434-924-4859 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/harris.htm

Robert C. Higgins

University of Washington - Department of Finance and Business Economics ( email )

Box 353200
306 Mackenzie Hall
Seattle, WA 98195
United States
206-543-4379 (Phone)
206-528-0340 (Fax)

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