A Synopsis on “ Cost of capital techniques used by major US firms: 1997 Vs 1980”1

Course: Corporate Finance

A Synopsis On
Gitman, L.J. and Vandenberg, P.A. (2000). Cost of capital techniques used by major US firms: 1997
Vs 1980. Financial Practice and Education , Fall/Winter, pp. 53-68.

Submitted By : Ashish Khadka, MBS Third Semester, Roll No. 02

1. Introduction
Cost of capital is one of the key factor used to allocate firm’s scarce financial resources to long-term investments. Cost of
capital serves a good capital budgeting decisions. It is used to assess the shareholders value added by long-term
investment and also to value the ownership of a firm. The increased attention to cost of capital and its role in capital
budgeting and valuation analysis attest to its important pivotal role in firm’s strategic decision process. This study attempts to
identify the cost of capital techniques practices among major US firms. The past study, such as by Gitman and Mercurio
(1982), has documented a significant gap between financial theory and practice in understanding and implementing cost of
capital techniques that were presented in financial literature. Cornell, Hirshleifr and James (1997) found DCF technique as
primary technique to measure firm’s cost of equity; CAPM is typically viewed as secondary technique. Bruner, Eades, Harris
and Higgins (1998) reported wider application of CAPM to estimate cost of equity.

2. Purpose of the Study

The basic purpose of this study is to assess the current cost of capital practices of the leading US firms. The study also
attempts to compare current practices with those profiled in Gitman and Mercurio’s 1980 study. Besides, the study integrates
these findings with observations of other research reported during the 17 or so years since the 1980 study. The study allows
academicians and practitioners to reassess their joint progress toward the development and adoption of improved cost of
capital practices and techniques.
3. Survey Methodology
The study was based on mail questionnaire survey among CFOs of firms listed in the 1996 Fortune 1000 listing. The
questionnaire contained 23 closed-end questions constructed to enhance the response rate. 21 questions were identical to
those included in Gitman and Mercurio’s 1980 study. 2 questions were added to address an important issue surrounding the
cost of capital weights used by respondents, as raised by Ehrhardt (1994). One response choice was expanded to allow
respondents to indicate whether they used APT to calculate cost of equity.
4. Survey Results
Relevant source of capital: Consistent with the 1980 study of Gitman and Mercurio (1982), respondents indicated that,
except for current liabilities, they tend to include all their long-term financing sources when calculating the cost of capital.
Substantial number of firms excludes certain sources of long-term financing, for example, 35% of the firm with financial
leases and 21% of the firm with preferred stock exclude these sources from the cost of capital calculation. The finding
suggests that the respondents’ approach to cost of capital calculation differs from the textbook approach which includes all
capital structure components
Weighting scheme: The results indicate that most respondents use some weighting scheme to determine COC. The
respondents using the cost of specific source of funds, rather than a WACC, declined around by 50 percent from about 17
percent of respondents in 1980 to around 8 percent of respondents in 1997. The use of WACC increased from 83 percent in
1980 to 92 percent in 1997. Of the firms that indicated the use of a weighted average cost of capital, about half used target
weights both in 1980 and 1997.
Measurement of specific cost of capital: Respondents of all types of capital indicated that they did tax adjustment mostly
for the cost of debt. Slightly more than two-thirds of the respondents indicated that they used current market-based costs of
similar obligations when measuring the cost of debt and preferred stock. Most firms were found using one cost of equity
capital, not differentiating the cost of existing equity from the cost of new common stock. The data revealed that firms use
more than one approach to calculate the cost of equity and majority of the respondents measure the cost of equity as the

Submitted By: Ashish Khadka, MBS Third Semester, Roll No. 02 Page 1
 A Synopsis on “ Cost of capital techniques used by major US firms: 1997 Vs 1980”2

return required by investors. Of the about 70 percent of respondents using the return required by investors, nearly 93
percent of them use the CAPM to calculate cost of equity. This finding suggests that more firms are moving toward use of
the CAPM.
Actual cost of capital and stability: About 86 percent of the respondents had an overall cost of capital between 9 and 15
percent, while in 1980 study about 65 percent respondents had an overall cost of capital in the 11 to 17 percent range. The
maximum COC difference for 1997 compared with two years prior were noted to be in the range of less than 1 percent to 2
percent, the maximum range was from 2 percent to 4 percent in 1980.
Risk classification and adjustment procedures: The majority of the respondents both in 1997 and 1980 measure project
risk individually or group projects into risk classes. Surprisingly, about 23 percent of respondents in the 1997 study do not
differentiate project risk specifically. Those firms that do consider risk differences most often do so on a project-by-project,
rather than on a group basis. Majority of the firms used risk adjusted cash flow or risk adjusted cost of capital or both in 1980
and 1997 study.
Risk assessment factor: The result for current study indicated that, as in 1980 study, the size of the project, the
relationship between its returns and those of the firm’s other projects, and its payback period are important considerations in
assessing the project risk.
Use and understanding of common financial techniques: With regard to the respondents’ familiarity with the
techniques, majority were familiar with most of the techniques. Respondents in both study were least familiar with certainty
equivalents- the capital market line and the security market line – and between 1980 and 1997 their familiarity with beta,
sensitivity analysis, the capital asset pricing model, systematic risk reflects increased awareness of CAPM and its underlying
constructs
Frequency of COC calculation and application of COC: The response indicates that the majority of respondents in
both studies, revise their cost of capital when environmental conditions change sufficiently to warrant it. Nearly 90 percent of
the respondents indicated that they used one cost of capital regardless of the total amount of financing required.
Capital rationing: The results indicate that dominant cause to involve in capital rationing is a debt limit imposed by
management and need to achieve certain financial targets.
Project approval and follow up: A final group of questions addressed the approval and follow up procedures employed by
respondents. The findings suggest that firms today employ more formal processes and procedures for project approval,
particularly for large outlay projects, than they did in 1980. However, in 1997 the follow-up on accepted projects once they
are operational, occurs less often and with less frequency than was the case in 1980.
5. Conclusion
 Use of long-term debt and equity is more popular when calculating COC.
 Use of some type of WACC is more popular than specific COC.
 Most firms use WACC based on market value weight.
 Majority use the required rate of return of investors and calculate it using CAMP is most preferred
 Average of COC has been declined in 1997 as compared to 1980
 Project size, the relationship of project returns to the firm’s other projects, and the project’s PBP remain the most
important factors in assessing project risk.
 Most respondents re-compute their COC when shifts in long-term rates occur. Use of the after-tax cost of debt to
make both lease-purchase and bond-refunding decision is more popular.
 Fewer firms in 1997 (47%) than in 1980 (56%) have formal procedures for evaluating existing projects.
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Submitted By: Ashish Khadka, MBS Third Semester, Roll No. 02 Page 2