A Practical Approach to Solving the Circularity Problem in Estimating the Cost of Capital
15 Pages Posted: 13 Aug 2003
While valuing a company using the DCF approach, we face the well-known circularity problem, where we need to know the cost of capital to value a company, and we need to know the value of the company (in particular the market debt-to-equity ratio) to find the cost of capital. Usually, analysts use the market capitalization and the book value of debt (if the market value of debt figure is not available) while estimating the cost of capital. Since the final equity value that one gets often turns out to be different from the initial value (market capitalization) used to estimate the cost of capital, this raises questions about the very valuation method itself.
In this paper we suggest a simple and practical approach that can be used to solve this circularity problem. In particular we suggest an iterative method that can be used to find the actual value of equity that one should use to estimate the cost of capital and subsequently value a company even when the market value of equity figure is not available or is not reliable.
Keywords: cost of capital, circularity problem, DCF equity value
JEL Classification: G30, G31, G32
Suggested Citation: Suggested Citation