Best Practices in Estimating the Cost of Capital: Survey and Synthesis Robert F. Bruner, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins hs paper reese res of cosafcapl vey of 27 hgh regard eopaaton, on leading ance ebers and re be slag whoo and ade boo Te ea sh cst ‘lgnment among l hegre te neo mon hore reverie on may pas ‘atintion fade vrs howe fr the lca of he rier rate bt oe uly markt i prem al for sine’ af el ats fore ivemen Mae. ‘ere sur we rma pment for drt opronches nd rere repent se son ade ued by pacts (J G12 Jn recent decades, theorescalresktoughsia see areas prfolo dlveaton, mart effin, ad ing bave converged into compelling ons about the cot of cata to 8 omporatio. By the ety 1990, »consasts bad merged. prompting such doserigtlons as “adltional. textbook. ppropiats” “toot coect.” nd "a wef rae of thm and g00d ‘hele Heneah this general agreement abou est ‘ot-capial theory lies cousderable ambiguity and confsion over bow the theory can tet be applied. ‘The issues at stake are stilay import tat sein choices on afew key elements ca lea 0 ‘vide eaprts i etimaed cpl cov. The cot of tal f central to modem fsaace touching oa resmeat and divesineat decison, eases of ‘econoniepoft, performance appeal snd incentive ‘ystems. Ech year i the US, corporation ‘Bove tan $500 billion in epi spend alr of gina Coen VA Sei Rota ay of ‘G30 ost) siteenc of few peceat a capital cos aa etn ving inbiliosof expenditures, bow frm eine ‘hocostisno trivial mater "The purpose of tls papers o preset evidence on hhow some of the most fiaeectaly sopintested ‘companies and flunelal advisers extinate capital out. Ths evidence i vlsble in severe! repost. Fit tienes the most important amiga the sppienton of costes theory, sting the sage for productive debae and eaveateh on thet ‘solution. Second, It hlpslaerested companies benchiark their cost-fcapial estan practcer gsnstbest practice pecs. Tid he vide beds Tipton the accarny with which capital cus cn be eatonably estimate, eebling executive 10 we te ‘stints more wisely in tei olon-maeg Foe, IRenabloseaher to snrwer the acitablegueston, “How do companies really estimate thet cot of capi” "The paper pst of lengthy tron of surveys of industry practice. Among the more relevaat reecraoes, Glimaa and Forester (1970 explored the level of sophistication in capital budgeting technigues” amoag 103 lege, rapidly growing businesses, dng tha the ateral rate of eum ad the payback period were in common ae. Although the authors Inglred about the level ofthe fiat discount rate hey didnot ask how the rte was determined Ginman and Marea (1982) sreyed 177 Fortune 1000 firs abot “creat practice in ot of capital measreent and uz,” concn that“the esondes actos do notsefict th plication of curt nadia theo" More ng Reis (1983) ‘areyed 298 Fortune 30 firms on the we brood ‘ery of anal techniques, contig rong eet thigs, that 868 of fons surveyed se tne adjusted ial badging tcniques. Bleman 1993) sored 74 Foctane 100 companies reporting that ll we wore oon of diesouning inthis eign. and 93% eiphted-average cos of epi. Ina oad: ‘anging survey of 34 Foran $00 arp finns ea ores 20 est sal companies, Trahan tnd Gitnn (195) por tht 30% of respondent ase the capta-et ‘ing model CAPND, “This paper fer rom its predecessors in sever Important respects, Existing published evdeace i aed 0 writen, closed-end surveys sent fo age sample firms often covering a wide any of oe, snd commonly asng mulple-chciceor ivinthe. blank questions. Such an approach often ies response rates a low a 20% and provides no ‘pporaitytoexplor subtest top. nsed, werepor te eat ofateephowe survey of scarey hose group of leading corporations se fsnal advisers. Another important aitferece is tat the lnteot of exnng papers Is moe often to leas how welluceped modes nao tchrique ef among rcldones, wile weare interested nthe sea of outof-apial estimation where finance theory is silent ot ambiguous, and pracidones are left thal owe devious, ‘Te following section gves belt overview ofthe weightedsaverage cost of eaptel. The eseesch spproach and sample selection ate discussed in Seston TL. Section TH eeports the general survey ‘sus. Key pats of dispar are reviewed in Soctoe 1, Seaion V discusses further survey reels on isk adjustment toa baseline cost of capital and Section Vi offers conclusions and impletios for the nancial praatione | The Weighted-Average Cost of Capital ‘Akay insight fo ance theory eth ay we of capital imposes an opportunity coon investor; ‘nmely, fs ar ved fom ering a rete on the next Beat equl-sklavestmest. Since invesiort ‘sve accesso wha of faunal mare! oppor econ ss octal st be bene ed aga ‘hese opt markt altratives. The cot of api Provides this beechmark. Uses finn eat ear i ‘tees ofits costo capital wil pot cee economic ‘Rofo vale foravestors, ‘A sandad mean of expressing company’s cost, of capt isthe Weighted-average ofthe ott of ‘PUANELAL PRACTICE AND EDUCATION — SPRNG/ SOMME 168 Individual souren of capital employed. a symbol, company’s weighted-average cost of capil (or WACO)s WACC = Want lKa) # pan) +O KD o where 1. = component cot ofepital For simplicity his fomaula actos only hee sources of eaptl tan be eal expanded ncade oer Finance important servtcons when esaaing & company’s WACC, Fist, the capital costs appearing fa the equation shou be curvent cons reflecting eure financial ‘market conditions, not historia, sunk cost. In ‘essence, the cost should eqeal the lavestors™ ‘icipated intra eat of er on fre cath ows sociated with each form of expt. Secon, the ‘weeks appening ln the equation sould be mkt ‘eight hisrel weights sed on ota eiay, ‘uote book rales. Thiet, becom of debt shoud be afercorporse ta, reecting the bene of teas, edoebly of interes. Despite the guidance provided by finance theory, ofthe eightd-aveageexprosion to estimate 4 company's cost of capa all confronts the ‘Faction with anumbe of iia chiees°Asout survey reals demonstrate, the mort netlesme Component of WACC estimation the cot of gu pal; for une ready avallable pss in oad nists, no observable coentepat exits fo eqs ‘This ores pactiioes rely on ote aac Indiet methods to estimate the cot of sity ep UL Sample Selection ‘This paper describes the resula of wephone stvey ofleatng action Belling ate complexity Of the subject does not lend itself toa writen ‘usstionaait, we wanted o slit ao explanation ot ‘ic finns aproac tol a the prcitone's ova ‘words. Though our itervews wee puded by esees of questions, these were sulfclendy oper sade to Saeeermara on mre iis coetaerrco ate oe eee ae of ig ie ya‘RE EADES, MARRS, & MGNS-—BEST PRACTICES MESTATING COST OFCAPTAL 7 reveal many sub difference ie paste ‘Slace out fru iso he paps eters theory an spplizaion rer than on average rie paces te aimed to sample practones who wee lads in the eld. We began by searching for sample of corporations (ater shan lavetors or fname ‘vise ihe Belt tha they had ample motivation to compute WACC earefilly ano rerolve many of ‘hecatinatn ines themselves, Sever poblinton# fers of fms tat are weer in incr of base, we chase a research repr, Creting World. (Class Financial Management Stroteries of 50 Leading Compenies(1992), which ideatife fs Selected by thelr pees as being moog thoee with ‘bebest nancial management Firms were choses forercllence instep Recs isk management, ‘ax and accounting. perfomance evaluations, ther arer of finan manent. The ompasieincaded wer tose that wire exons ‘he grew namber of tines by tec peor From he 50 companies deat his report we timinated 18 euequarteredoutlde Noah Amedea? Of thts remaining, ive declined to bo interviewed, leaving sample of 2 firms Te companies included {nde sample are contained in abl 1 We sporeaied the most ssioe Sancta offer fist wih ete ‘lasing ooresenc, and then with atlepbooe cl. ‘Our equst wast trvew he nv in charge of esti te fim's WACC. We promised oar Jnerviewees tts preparing repo on orgs, ‘we would not ideaiy te prctnr of any potcul Company by mame—wo have respected tis promise fn or presentation In the intrest of astessag the practices ofthe brosdercommusity of fiatce practitioners, we surveyed wo oer samples: + Financil Advisers. Usiag "league tbe” of ‘merger ad agus advisers peseated Inatntonal vento tes of Ape 1985, 1994, ‘nd 199, wedrew asumpleof 1Dofte mart, ‘pel cope mig ot nde a aay xs ‘ance sepa rug «oe CF, (Glow coe ed ure oon op yb [Skpooe mre fui lane Cp 92 ‘Steyn ince el pb aes SS Sa ace tive advises. We applied approximately” he Same se of questions fo epresetatves of these firms mergers and sequision departments, We \wondeed wheter the Gael ase iatrest poming da ight lend mio lower WACC ‘climes han hone extinated by operating ompanie. This proved aot be he ese. It snyhing, the estimating techniques mos often ‘hed by financial advisers ye gher, oot, pial cost estimates. “Textbooks nd Tadsbooks. From sang textbook publisher, we obtained iso he _radaate evel textbooks incomocate finance ‘ving the pretest onsale 1994 Frome, we elcted the top fur. nado, we ew on thre uadebooks that discus the emation of WAGE etal Names of vies an books lcinded in thse wo samples ae sbown a Exh. IM. Survey Findings ‘The dled survey els appeara Exabie2 The eximaton approaches are only sna cose he three sampls in several dessins. + Discounted Cash Fow (DCF) isthe dominant, lavesunestevaleaon chaque + WACCis the dominant count te ted in DCF analyse. + Weighs abuse onmarkeraotbeo value mines of cbt and egy" Tow aera cost of debe ie padominanl based on marginal ret cone and marginal ‘anor x tes. + The CAPMis the dominant model for etnatng ‘he coo equity. Some fms mentoned oer mul-factor ase pricing models (eg. Aciage icing Then bt hse were inte sal lao ‘ers pon te meen fro ae ey. ‘Gree neon ie, cng ef at aiaFINCA PRACTICE AND EDUCATION. SPRING/SUMMER 188 Exhibit 1. Three Survey Samples ‘Company Same "vier Sanple TenbooTraarbook Same imosacs “SR ease Teo eee ils Ret Bray ed ge ‘cee Dar oni thin eee Begin on Gop (alr One “Mas ‘Gene Gers cane Ros, Wesel at ae ‘CopmePiatne Vette "Taacbeet Goce owg Sey Cop Kale Mia ‘cons Stoo Beer ‘Bue ae Kota Seubbeney owen Asc ieee wane Pe haan nde Bowie Patt ental ‘eso Masa Mer Mensano Pepto er Oxs Seg eh Uses Catie User ‘Wat Dey Woyshnene No rms ced psitic modification ofthe CAPM. ‘oadjst foray empire shortcotings of te ‘soln explaalag pst retuna? ‘These practices fe sharply from thre reported in earlier surveys. Fret, the best practice firms show moch more alignment ob most elements of practice, Second, they base their practies on Financial economic models ater that on rile of thumb or arity ceision ules ‘On the other han, daagronments exit within and among groups on ow wo apply the CAPM Ib estimate ‘tof equity. The CAPM sates tat the seed ‘etm (on ay asset can be expressed K=B+BO,-8) ® wba A, = Interstate aalable on iste bond Fa tae, gm eh ie CA os ines a ts soe Sa me {BE feminine (989 th iid {CRS nien messed CaP ete ela inaimuedeelmme eeeae ‘St iman nt Free 97 an a Moo 1 = saturn required toate investors to bold the broad market pert of aaky ase B= the relative risk of he parole ate. According to CAPM tho, the ost of, Ky fora company depends on three component: eis onthe bonds (Rp, the soe’ uy beta wich ‘measures kof the company’s tock elativeto other ky asset (= 1.0 average isk, ed the market ‘is premium (RR) secensr enn avers to old isk asset geoeraly vrs ike bonds. Ta theory, etch of tse compoacats must be a forward looking estimate. Our survey esuls show beat slsagreements on ll ee component A The Risk-Free Rate of Return As originally derives, the CAPM is s sngle- petod mode, ote question of whieh interest ate Sestrepresens the rirk-fre cus ever arises, But {na meay-period word typically characterized by uppard-soping ye eurves, the practioner mat ‘hoose. Our results show the cbse is typically ‘between the 90-day Treasury bil ysl and «long. term Treasury bood yield see Exblie3), (Because the yleld eure is orinaly relatively fiat beyond ‘enycars the cole of when priate long. tetmBRUNER ADEs MARRS, 4 HCOMG—BEST PRACTICES MESTIATINGCOSTOF CAPT ” [Exhibit 2. Goneral Survey Results ‘conentions Fon Aaa TbeyaraeDe ee tc raies 74 yey Sp if ape “peocr ns eau os {ORDO end ey stig they ‘enc apo me tool wy eee soa LS eyacon dep ae we wae Conomuyhyende A MaaCAM VRC acng mind Ofer mots in swe Canes ena “cana reas Gren a aoa ate Ma (ny mt teExhibit 2. General Survey Results (Continued) wut ba ce cpu cto edo Sowcsataind eke i Faeelo ‘aaa Tarn acti ot oe seine 1074 (Se a on St ot 50 ‘ein ise cuamae eedet ‘cn ey — SoBe pena men —whasaTatbesiné Sota ‘ein ape el 15 sh aes ‘ottpine cy ‘Senna aes = 1 ting no 206 aa esas ae seen rn ‘asst WeDo ay tthe th it SSeatineenes ‘sient Big eee ore ey rina yr compa att a Pogue te en ‘Sip ye com ie ‘sala and Invomaat cnet atten iter to See Reaate eee Naat Soca ay TR Wate mupinaed —og_No oye een wore na nt oper aan ett oe Sn[BRUNER FADES, MARRS £ CONS PRACTICES NESTMATING COST OF CATAL 0 Exhibit 2, General Survey Results (Continued) ‘te ag mnt Nami ORM ers thet WAC ‘Spy oon et ae Ce ase im dering ‘eve sans hm rete teem een py yore Saecetefon ‘hese an aay inne ot cn ‘rote ate ee divontem on pom epetn, ame aate 2 wg ote le pant perso oe 73 poe wa yield to ee ir aot wets one.) The dference| between lied returns onthe 90-4 Til and the tensyeatT-bond bas averaged 10 basi ola ‘over the long run so choie ofa rikfre rat can fave a material effect on the cost of equlty snd waces* "The 90-day Tyas are move consistent with ‘he CAPM orginally delved and elect aly ask tice return th tne that T-ilinvetort av ‘aera oe in velo from atest rate movement. “However, lng-em boad yes more closely eet, the defule-tee holding plod reuras nvadble ca eg is ts eer = Si mecca coe cee Sees rcs nd gn em ed ha fn ae bo Tong lived inverters and tus moe closely ior the typeof vestments made by compu, "Our survey esa rvedastongpeerence onthe perf practioner for logtxm bod yes, OF Both forportons and faunal adviser, 7% os Treasary tondyede matures often yen or greet Non of the inca advisers nd only 45 of he corpcsons ‘sed the Teoauy Bil yield. Many corporations sid they matched th fem of be ik oe re th eae ofthe lavestmeat In contest, 43% of the books vost the -il l,while oly 29% used ong ‘ern Treasury yes, B.Bota Estimates ance theory cil for fortart-oking bets one seflectng invest’ uncon about the frre cash flows to equity. Beeaeforwarddocking betas ae ‘nobeervable, practitioners are forced to ely 03 proxies of aout nds. Mor often ti valves sing beta estates derived fom bistorlal Gata 206 Dablished by seen sours Bloomberg, Valve Line, nd Standard & Poo "Te ual metodo slope coetiient of he market modelo et Rea) ® ve 1, = sumon skin pind 4. tk sontExhibit. Chole of Bond Market Proxy Sone for beta comps std ha ly ice of a bod make pry fo ek le “pence cel baw bey wae pope Spend fan: We std, "Wha do yu rca Feeras” and ear following + cane Trey bond oct urtion ‘reasiy boo i add totes wae pect elon” "Waseda il, hehe opal tages omy evizo wi my fd ————— ES = retro the mare porto in period = repression coma for stock and 2B Shesforstocki, {I adion to relyiog on histori dat, use of his uation to etna bet requires anamber of pact sompromises each of whit can matty fect ‘ens. For instanc, cresting the numberof tine en in the estimation may improve the tated celibliy ofthe exinats bu aks the inclusion of stale, elvan information, Stay, Sortening the observation period from monty eekly, oreven daly aceases the sia ofthe sample ‘ut may yield observations that ace aot ormally sstbted and my inode unwasted ado nts, A third compromise involves chice of te market. index. Theory dictates that Rls thereto te ‘market porto, an wasbserabi polo cong of a iaky ase, netoding human epitl end tet Bonded tes, a proportion tts impertanc world wealth Bets provider use a vcety of sock ‘market inde ot proces fo the market proto oa the argument that stock mashes ae eaima suiclently wide aray of assets to be adequate ‘suoguis forthe unobservable mace’ poole, cb shows te compromises undying bebe ‘atinates of thre prominent providers snd thle combined effect onthe bet extn of our sample scompsies. Noe for example thatthe mea tao er ‘ample companies ssordng to Bloomberg is 13, while the same uber ssoding tae Lines 28, [hibit provides acomplate iat of sample betas by ubisiee (Ore ba of te corporations in or sample (tem {en Exhibit rely o published sures for tei eta ‘stits, thowgh 308 calcite thir on Among ‘sacl vies, 40 ry om publihed sources, 20% alsa ther ovn, and another 40% ue what sight be called “fundomeatl” bets estimates, These soe ‘estimates which use multctor stata! madels raving on funda indies of fem and Sdasey Fumi pracTIN AND eoucATION — sPméa/CUMMER 108 Exhibit 4, Compromises Underying Bata Estimates and ThelrEitect on Estimated Bolas of Sample Companiee ‘Sandard Bloombergt _ValueLine & Poors 7 io a Timelteral ety) wt) wat ym) Miietinder “Sdpsib) wvstCnyoan “88? 20 Pro MatanBeu 10 10131 7 he Ray vo pie aes Sst oe ni nan ao Siete acento rh md ee satan h nt ie ‘isk to estiate company boas. The bat Faowa provider of fundameatal bets estimate is the ‘onal fim BARRA, Within these boat categories, a aumber of survey participants indieted tae of more presmatig sppoacies, which combine pubes beta eats or adjust published ese in vaous beuriate say eo Estes) (©. Equity Marka ek Premium This topic prompted the greatest vaiety of ‘sponses among suey paisipaats, Finance theory ‘athe equ mare tk prem shou equ the ‘exces re expeted by investors om the achet ono relive tories ast, How oa measures, expected future retro the mart porto anon tlsless aes ace problems let to practitioners ‘Besa expected fru eure ae uber suvey respondents exalted kitts ata fhe fete on the presumption that pest expeiace heavily condone futate expectations, Where espondens chiefly differed wat lather ase of arithmetic versus geomeric average historical ‘uty tetms and intel choice of realised rtues 00 T-bills versus T-bouds to peony for the getarn ‘on isles sees, ‘Tarte mean eum the simple average of ast rtums. Assuming the dstbuio of roura Sable overtime and thet periodic returns ace independent of one another, the sthetcreten is the best esimator ofexpecied ru.” The goons ‘ean return i he lateral rate of ret berwcen single oulsy and one or more future rovepts, Tt‘BRUNER FADE, A, A NGG BEST PRACTICS NESTMATING COST OFCAPTAL, ” Exhibit Betas fr Corporate Survay Respondents ns nit Blanton's sje bea = (D6, +(039)1.0 an Vale Line opal ol DebTot apf tee Bom, eatin the eet US ain Wh LT Deol Cap wa eat Bian Bo i “sa ‘te ase ry glean a mn com 136 ue i un ae aero ta 16 — ost os es on ns writ oon 093 0 96 on ‘measures he compound ats fetus investors caaed ‘ver pat periods, seca potayy histo Investment expedeace. Unies rum are the sume cach ine pro, he geometric average wil alaysbe [es tha he arithmetic average andthe gap widens sereturae become more lata. {iin med ra ty spe se en ‘Suse eset eae 0 pag ne a lyase se ee lnpn a a ype of eng ‘Bed o boon Associa’ dt (1985 fom 1926 0 1995, Exubie 7 sues the possible ange of uly markt sk premiums depending on use of te [rome as opposd to the arte mean eUity {sti and ue of realized rtm oo T-ils Spposad to Toads,” ven wider veins in market ‘So penlums can se when one changes these ed for averaging. Exteading US stock experince (i), whe ee as So tm ne rp Compe Soe it dt te enn Svat2 HANCEAL PRACTICE ANOEOUCATION — sPNG SLE E88 Exhibit 6 Bota Factor ‘Neate ney opi “Win yer ‘Soctecicslnnaway sae + We oe aja bts epored by Bon ‘Avnet sn has tra exe voll It prt ins the face cos observe 6-noath ovutanceberveen or ck end ack ‘Weslo soni, Value Lio, te SP betas forcompucnon ad my adj econo ‘ouch sbesomen of ure Fak” + Seance Meri Lychan Ve Line cs snd Blomberg etek” edo ot Bets ena ok leet Our eoepany bet bit wr ‘ih vege of urbe ep eta ‘Ge opment bet se etated wy pr iy fia es of spare compe Exhibit 7. The Equlty Market Rsk Premium Gy [FRI Returns Yond Raton ‘Tite ry 708 Mea Retira Geoaarie rd sas ‘Moen Retca SL backto 1602, Sige 195) shows thats market. renisave changed verte twee ply lover Inthe pr 1926 pid Carton end Lakin (1985) itusate considerable vant ia histories pean ‘ing diferent tine pad and methods of etaton Fen with dt sacs 126, OF the texts and tmdebooks in our survey, 715 sopptt te ofthe arte mean rem ver ls 8 the Dest surrogate forthe equity market Hak premium, For long-term project, hv (1988) advocates forecasting the T-il te and sing 2 itera cost of equity foreach fue te peed, aplan and Roback (1993) stale te equity ak ‘remiom implied byte valuston nb everaged ‘masacon nestinsteda mana pein of 7199, hich s mos consistent withthe ane mean nd ‘lls Alnor view i that of Copeland Kallen, Marin (1950), “We beleve ta the gromests verge represents beter estate of vests ‘xpored overlong peiodsof tine” Ena (1998) ‘ecommnends us ofthe geomet mean rt if one belive stockholders are buy-andhold investors Half the anal advisers que we premium consistent wth theihmete mean ad i retuas, ‘ndmany specially menooed we of the rites tmean. Corporate respondeas, onthe otter hand, rienced more divest of pion ad tendo favor Slower market premiom: 37% wea prem of $65, 2nd another 11% ane an een lowe figure ‘Comments in or icteviews oe Exh 9) suggest, the diversity among survey paripats. While most ‘of our27 sample companies apes owe 2 60-year ‘soil prod oes ret ond window fess than en yar, wo ced windows of shout oo eas, one began averaging with 1960, end anor ‘i i952 ‘This variety of practice shoul not come wpe sine theory eal fora forvardoakng isk premium, one tat refets crrent musk sentiment ad ny hang with mart condone, Whais cers tht ere is substat A alin rests hat few respondents esl ed ‘eof ay forward-looking method t sppeaet ot replace reading thee leave fps en |, The impact of Various Assumptions for Using CAPM. “Toitlesate te efecto hee various practices we estimated the hypothetical cst of equity aed WAGE for Black & Decker, which we lcentifed as having & wide range in estimated beat, and for MeDosal's, whick bata relatively mtow range, nr eatinates are “hypothelal” in that we donot adopt any information supplied to vs by the ‘companies bu rather apply fange of epprocches based on publicly available iaformation of late 195 Enhibic9 gives Black & Decker’ enimated conte of equity and WACC® ander varios combinations of she rate, bets and market sk ‘remia. Thee elutes of praccs are ilustated, ‘uch in um sing hee betas a provided by $F Value Lin, and Bloomberg (onajusted). The fist spproach, as suggested by some fens, ares 8 short-term lakfres rate (90-day Tl ysl) with otion's arithmetic mean (ssing Tbils) Tsk spell cd fre ‘sng ar ‘ain tec a von mie ei hg pa wen[ROMER EADES MARRS, & CINS-AEST PRACTICES ESTATE COST OFCAPTAL Exhibit 8, Market Risk Premium ~Gir do yor ie your marital RoRIIGT A Ring a apis soa at parse OSE ‘owt te soe cn ts cpa oe + -Oar4ao basi point at nie asd on he ital loan af eens on mule basi ‘lor invert ann eine ooe of py aed als ennnspesies™ + "Weate ston atime arage tarigi 160, We av ed to lavsineat aks ad onaing ‘maw oie om 37" 1+ Ager avenge of shut 78. This sumer ta Sea wed fora tin nth company anise ‘Ges saeGaae a iode vio, Moy conse og ne con 0 ua tina srs” + "Wea carey ng 6 109, we ple cos nett asd cade st cnt {otis epopin te dota beowers 2 but mot ween ad 7.3" ‘Comments fom fui evita were even. Wile soe simpy responded hat hy wea plished ‘noel vege, presented moe comple + "We mpl tind (int area). Ault ofthese init, Wook tt inbto a nd fossa mre cet uy ote 30 Yur batt nota cepit30ye avg). ‘Wense toting einige, Mone Cao sinsaion nda ceed discount medal one SP 40 ‘elma wha Ge pen hol be, ven ot ie rate of ar.” + SWoapeh 74 att ean, aie Btn, Singtel Weasdtn see omar ena ling ‘en ss db wy cue oe ntmeeeua hen we oad iar aor omen Wee ‘Sigh tet ean doco ie ere ing” premium. The second, adopted by a aumber of Financial advisers, uses & longterm sees rate (Go-yeeT-bond yield) anda ak premium of 72% {Ghe modal prenium mestionedby Sauna vse). ‘Te thie approach alr ser along iste ‘otadops themed prenom mension by copra respondeas of 53%. We repented these general ‘procedures forMeDonald’s. "The renuing ranges of estimated WACCS forthe won ae irons Maximum — Minimum InBasie ‘wace” —"wace” Pointe aioe aso 160% 930m 290 ‘The range fom mlaimam to maximum ie large for both fms, andthe economic impact potentially stunning. To state this, the present value of a level perpetual nau sein of 10 milion would range between S78 lin spd $18 aloe fr Black fdDecks,nbereen S86mlion snd S108 lion foeMeDonsl' ‘Given the postive but relatively Mat slope of the ‘eld curve slate 1985, mos ofthe vation in oot Ise sexplsnes by bet end the uty market ‘rbalum assumption. Variation canbe even more dramatic, rpcily when the yald carve slvered V. Risk Adjustments to WACC Finsoce theory is cle that «slagle WACC ie sppropriate only for investments of broadly comparable rk fm'sotell WACC Isa slab beachmack for «firm's average esk iovesinens. Fsncr theory goes ono say ur such a compaay- spect igure shouldbe adjusted for departs fom ‘ch an average ik pole, Aer eapial ques paymeet of premium at depends cask ‘We probed whether fms use 1 discount rte epopte tothe iss ofthe flows being valved in auestons on types of investment (sategic v Speratonal, terminal values, synergies, and iuliivisional companies. Responses to these ‘questions dsplayed Ia Eshb 2d ot dsplay mech Apparest alignment of practice, Whea fianci tvirers wete asked how they valve parts of ‘mulson ms lle fs erveyeepoed it they are liffereatclsount rates for componet pt Gem 1). Howeve, aly 26% of companies always jst te cota capil refet the ik of invidsa investment opperantes (item 12) Earle stadies (Ganmirizedin Gan and Merc, 1982) reported Tat between onethird and oxb-baif of te fms surveyed did mot adjust for Hk diferenes amoag ‘ipl pont Thee practices Sand instar coutExhibit, Variations in Cost of Capita WACC) Estimates for Black and Decker Using Ditferent Methods of implementing the Capta-Asset Pricing Model ati Exh. n sess he CAPM is edt etna cat ooh oof bs asad be 7.8 Bed on Binge a te sso ob 08, raed repeat ef cpl ‘ane Sor Tr ae Pc A ora ica roto (ramen iy ve es) Bras, 90-9 Po RL-R+B508, oboon etme aap nce 1936 Costot equity ost ot capa Besser 5 ‘Wace Bloomers, Be 136 ids 3708 ate Line = 5 bare 1208 Sar pois ‘ie Lag Te Rie Par Rik Prono of 730% Test paso cial vis rp Rn 6dee, Soyer Tends R= 7208 wollen of imac ave Coster cont ot ca Dense x ‘Wace Bloomer, B= 106 308 30% ‘abe ine B= 68 ioe ey Sar Beit 0m 2108 "ena Tan Tr Bae Pa ik Pres 30 ‘rat pate ean ae Kis 626%, 30 yur bonds R508, model epee of croton, ostot uty cout of Capt iene oe re Blonbere, B= 1.06 alow 20% Vaseline, Bias 15308 020% 16108 0308 aig tees ‘othe rcommenditions of textbooks and tadstooks: the books di not expliely adrese all abject, bet en hyd they wee afr nth dvecay of Fsadjuseddssoant ate, ‘A closer look a specific rexpoates roves the seasons as thor based on taded fist ati doped fo decatos on lnvettnets in eal sits “neil ies can Between we of fase smatket ta versus ngs udgmeats. Responses fcom Gnencil advisers Musee thi As swan Ecibit 2 ll uviers are feet cai eon for ‘valuing puts (2g divisions) of afi em 1 ony hn ever select fren ates ose x stetale ‘opposites (item 18); aly one in tn ett any Inclination to se eer sou ets fortran! ‘ales nd nein es Nowa Gem 16) To spi Interpretations ar hat 1) advisers ignore iaporant skifeences,or2) mate rikeifsnce tee fn astessing factor sac a teminal alae. Neier of these it, our conversations with avers evel that they recogneeinportatcsk differences but eal with them in moltads of ways Consider comments from two prominent investment bass ‘who use diferent capital cons for valuing pas of ‘multidivision firms. When asked about risk djustments fr prospective merger synergies, these Same fem responded We mk tes adjustments in cash owes a slips rather ta ie cacoustates” + "Risk factors maybe ifn fr relizaon of synergies, bot we mak agents to ca ows ‘ther than te ieoust te” Wile Financial adeuersepcally value exiting companies, corporates ce fark eballeags, They outoely mas evaluate lavetat in new protic, {nd technologies. Moreover, they deal a at ‘uiminiswative sting tht melds ceatraized (eg. ‘alelating a WACC) snd decentralized eg, specifc projet appraisal prose, As Exhibit taste, thet completes ead bead of approaches for ‘aling wih risk A mumber of epondest mectoned speifc cate adjustments to distinguish between Aisioal expt eos, iratonal versus Gomeste Investments and leasing veces nonlcasing ston,‘BRUNER. EADES HARMS, HEGNG oeST PRACTICES MESTMATIGCOGTOF CAPTAL = Exhibit 10. Adjustments for Project Risk ‘When aed st hye ict eT pe, oman oad wi ange po 1+ Noy cae bee te ain sine retina we aa yas bet ean o ta dates fr ik nes ow pejactons ar ten nas fatal acts becte. ‘nig ajsments tcf eap cleatos td mating west alee ee, { commodtycons nd merino ate” Kt saber pl eae ote tate Sete nae ony the ot ft ae” None con's ajunt coat ofc, Webetv tae tro ic compaents: 1) proce ah aw, ih shold are nextel a2) dunt" The seme Sm ante, oweree “ot Insolvent ont is ae fo ony ad For eg rqetions he onpay esgic rater ce tims at ce capil + Noha te soa co of xpi cute waged weap coupe ‘conparion ad poe sje” 1+ Yeu we have clea cov of apo isons based coo apa. for pe play bets a lo sgget ‘bjt artes based on nc projet Ou feng shat eso dvsness he most ‘tegen neo ae compen)” + ret brat eat on ne osaion ‘des analy on vey poe.” have for aml ee bse: "orth mot ut we mak kanes gulintey Le we ae he corprts WACC io ease 2 oes bt ts nee tera szosng oe kof poplin aed. Ts cots i "ly ple wl be ejected een hongh tact cope aretha" 1+ Nodoneicay: yes manaly—we seat enum comma he cont of api son In other invtanes, however, these sae respondent favored eas low sjortment to dal with as. "Why do pacer ik adja sous ae ia fone case and work with eat flow ajutnets in nother? Our Interpretation fe that iseadjsted Aiscoune sae moe kay waed when the aalyst an establish relavely objective flnncal maket beachmarks fr what ate adjstmens should be. At the bosnes (division) level, dua on comparable fompanes provide costo capital estimates. Debt ‘markets provide suogaas forte sn esing eth flows, Iatratind ase nee being 00 toss-countrydifereaces. When no soeh matket ‘benchmarks ae avalabl, practioner ook to otee smstods for dealing with ss Lacking «goo market ‘talog trom which o glean lavestar epson Gi the om of ifering cpt cos), alti forced to rely more oa ner focus, Prac inpemevtation ofskadjased cscount rater thas pps to Spend fon te byt ld wade financial ast tht ae fomparaben isk the eat lowe bein ald and then to ave nancial dts on these traded arate, “The pragmatic bee of application leo comes 0 the fore whea companies ae asad how often they ‘eestimate capital cost (tem 13, Exhibit 2). Even {orthoses who rssnate elaively frequen, Ehibit 11 shows tat they deaw en Important capital costs and policy changes abou the capital cost figure used {nthe firm's decision making. Firms conser administrative costs i stracurng the plicis on apts costs. For very large venture (eg. 22 Scguston), capital cose may be evsted each ‘ine. On the oter hand, ony Ig material changes in costs may be fed into mote formal project, ‘valuation systems, Firms also resogaie acral tmbiguty in any cost muber and are willing tive ‘sts approsimatons While the bond market eas to mlaute basis pov changes in investor eetura ‘egolrements, avestmente in rel ata, were the evalon process iets time consuming nd often Gecentalzed, involve much less precision. To paraphrase one of our sample companies, we use pla costs as rough yardstick rater Wan the Inst word in project evaluation ‘ur interpretation is that the mixed responses to ‘questions about risk adjusting and eeestinating Aiscount cates reflect an often Sophistiatd set of practi! tradeoffs hese involve the sae of sk ‘erences, he qty of formation rom aoa Imasets, andthe cealtes of administrate costs and process, In cates where there ate material= ANCIAL PRACTICE AN EDUCATION SPRING/SUMMER 108 EXhibitt1. Cost Capita Estimates ow egsny do you reasinas You COBB Co of cpl? Has we ipo Rom Pa OTS sreouion * "eal evi genet but would view mre nue If kt ais hanged cough io wast ‘evn We mold aly mnomncn change ae tele ecompted number ws mail eet ‘he on urn beled” + cWe resins it once or wis yea, et we el ohunge the umber ht he uses ul se fot ‘ein and planing pupse. We expect the stale oY ves ime. but We so ene el ‘verae oe iy constant ove the besten cyl That, we oo masa realy dca ‘itn be company over dine” + sraliy every a months exept aes of very lee investments In which is tinted foreach + "Weesver meat, tc fren agen obi neste! propor" + sReauatnendg formjr tx changes bat ula ot of ep ge sia (ap 10 21% frases) ou eee et changes ise os uranic rab bn eat wed inst + “Poy set 100 ba pint cage publi chang. We rp only othe eres pret” Aiterences in favesiment to ge scale dministative comple, and realy stifle information fom fauncal markets, preciionet employ risk adjustneats to rates quite routaly ‘Acquliions,valingevistons of conpane, anys of foreign ves domes aveseat, ad lesng ‘yerus noalesing desisions wecefequetly cited ramples. In coast when oue of more ofthese {otro preveat, practioner sre mor likly 6 eoploy ober ean eal with ks, Vi. Conelusions ‘Oar esearch sought to idem the “et practice” in cosvt-cpital estimation through ltaviews of leading corporations and Taacil advises. Given the hoge annual expenditure on eaptal projects sad somone acyalstions each yeu the wie seston af iscooot rats is of materia nnporance to eeaior ‘upon manages. ‘The survey revesled broad sccepance af the WAGE sth bats for setting aiscout exes. In Addition, th survey revealed geaeral slignment in ‘nny pects of te estimation of WACC. The main ste of atale disagreement was lathe dats of Implementing CAPM to enimate the cost of equi This paper outed the varieties of prictce CAPM tse, the arguments in favor of differs Approaches, andthe precteal implicatn "in sommery, we believe i slements represent bert cu ‘timation of WAC: + Weighs shouldbe tated on mark-vatue mince of debt and equi. + The afte cost of deb sould be exnutd fom ‘marginal pretax costs, combined with marina! orton ax ates. “CAPM i curently the prefered model for estimating the cot of equity. + Bota are day substantially from published sources, preferring those betas uslag long Interval of equity rteras, Where a aumber of Statistical publishers disagree, best practice ‘often Lovlves judgment to exinatoa bets ‘Risk-free st shoal match the toc ofthe cash flows beng vals. For mort epitel projects and corporate sequins, he yield on te US overament Teaury bon of enor mae yee in Iurty would be sppropene. * Choice of an eouty market isk premiums the subject of considerable contzovery bath fo its value and method of eximation Most of our best-practice companies ue a premiam of 6% ‘rlower while many txt aod aaa sdvisers use higher figures. + Monitoring for changes in WACC shostd be ‘Keyed to major changes i financial market onultons, but sbould be doe a leat annually. ‘Actually flowing a change trough a orporate ‘system of project valuution and soaipensation targets most be dove ginger and only whenBRUNE EADES, MARRS, 4 GGT PRACTICES VESTUATING COST OFCAPTAL, there ar material changes. {+ WACC shoud be isk aut to eect, nbetatve ferences among Siferat ‘basinesesina orporton, Forinstnee, asl vise: general find the corporate WACC tbe Inappropriate forvaling fret parts of 2 ‘poration. Given publely waded companies ia deen siesta, soc ik ajastentival¥es tay modest revision inthe WACC and CAPM. Approaches areay aed. Corporation alto site the noe adjust capa cows seroe national boundaries. Ia sins where mater proxies for parialr pe of ik clas are notable, ‘est practice lnvaves ding eres to sceoont fore ference, Best practice is nrgoly consistent with finance theory. Despite Broad agreement athe theoretic level, however, several problems in application romal tht can endo wide divergoce is eatinated ‘spl cous Bated on these rnaning problems, te believe that further applied research on two Daocipal topes is warranted Fst, peeconers feed additioeal tools for sharpening the! {assessment of selaive risk. The variation in company-specilc beta entimater from diferent published sources can ereate large differences In fapitalcost estates. Moreover, age of rake ‘juste escount sates appears limited by Ick of 00d market proses for dllereat isk profile. We References eel ol tee of Sica Cit te Sor Re nrc 1 A gn J Sala aig i UPD A Dey, Rid nt Sua Ma, 98, Pico “gape et aad ta ; st ia believe that appropiate ute of averages arose Industry ov ote dak etegoi ea vente worth exploration. Second practioner could benefit for farther research on estimating equty market sok premia. Coren practice displays large vacation Sod focoss primal on averaging past data. Use of expectational data appears to be» feitful Spprotch. AS the next generation of theorles _seaualysarpen orinsghs, we fel thatreseareh Attention to implementation of existing theory can ‘take forrel improvements in prac, aly our research ina reminder ofthe ol ying ttt ots in business we mest with eo ‘vk witha pene, and et with ana. Dept he nun advances in fsace theory, tbe parla “ax” ‘valbleforestiatng company capital cots remains {blnt one. Bestpacice sompunies can expect fo ‘simnte thei weightd average cot of espe with 8 Secraey of wo more than plus or mlaus 10010 150, ‘sis points. This as important implenons for how ‘managers use the cost of ep indecision making. Fit, do not mistake capital badgetng for bond ela. Despite the tole availble, etectve cpt ‘ppasal coutaus wo raga thorauph knowledge of the business and wise basins odgment. Secon, Be arf otto how out the baby wi be bth wate, Donotijet the costo epitl nd atendant advances In ianeal managenont because your nance people tne aot able wo give you a preise suber. When Ia ted, even blunt ax i beter has noha. Copan, Te, Ta ote a Mari ttn “cin a eng eae of oat od Pi AK a ate 8. ap 4, tna Ur there, ua, asses Uo Ps i, Aah Ko abe 5. ibe 195, “Te Opi SRNeSagpeen os ee Bee hu, Mich, 198, The Ser for ie: Meoring hSonyCr apiB, "four ged eck Rea una of Pat moe os Onabe 3 an, Lect HB, Pip of Meng Pac, ‘Es New ae WY apt Petter oh= PRUNCIALPRACTIC AND EBUCATON — SPRING/SUMMER 198 Gna, Lowen ad cat Mari, 18, “a ‘Gla eis ed yr Fe Sure 2nd “Sch i emi nA Covi Fone ‘Phat Mange 31. oe Imhuo Asois 1995 tarbok: es, Ben Bi ‘hyo, Chea ‘Moun Acs, 154 era Co f api Qa ‘Sonera ‘open, alt Beg Boon, 5, “he CAP ‘Bes Tha Flare Metre Boe of Minseapls ‘hay Reena al, ‘ig, Sea lH 8 Reb, 195 “The Yeon "S'Ga Row fas Ao tie at” Soe {Pane 30 Spent, a am, Mac, 194 “at Pcs Nt Ke ‘iat ne” Pn As Soa 280 eae 25 ‘Sipe or ioe don wi Pcs tet ‘Stal Speatenion Te” Reenof Pct Sst (Gor, Sea tas ‘Pear Managemen: Feces Carel Bye Sie Cap ea oboe Poe "ewalon Sick Pr Hdenc nd ingles” Sa of Pel Eos Ose Ro, Se, Ranh eset sn ty ee, 96, ‘iota Pant as hg "Si yf Cp cag ‘ne 33 1 Mes 8 9, “he Bay Pra Stk eos Sse iba raced tts cna ot baa, Boa A Lane Gita, 95, "Bé ‘te inn Pctce Gp Corpor Fn A ted ince te ayia BO me