Cost of capital: estimation and applications

Abstract

List of Exhibits.Foreword.Preface.Acknowledgments.Introduction.Notation System Used in This Book.Part I: Cost of Capital Basics.1. Defining Cost of Capital.Components of a Company's Capital Structure.Cost of Capital Is a Function of the Investment.Cost of Capital Is Forward Looking.Cost of Capital Is Based on Market Value, Not Book Value.Cost of Capital Is Usually Stated in Nominal Terms.Cost of Capital Equals Discount Rate.Discount Rate Is Not the Same as Capitalization Rate.Summary.2. Introduction to Cost of Capital Applications: Valuation andProject Selection.Net Cash Flow Is the Preferred Economic Income Measure.Cost of Capital Is the Proper Discount Rate.Present Value Formula.Example: Valuing a Bond.Relationship of Discount Rate to Capitalization Rate.Applications to Businesses, Business Interests, Projects, andDivisions.Summary.3. Net Cash Flow: The Preferred Measure of Return.Defining Net Cash Flow.Net Cash Flows Should Be Probability-Weighted ExpectedValues.Why Net Cash Flow Is the Preferred Measure of EconomicIncome.Summary.4. Discounting versus Capitalizing.Capitalization Formula.Example: Valuing a Preferred Stock.Functional Relationship between Discount Rate andCapitalization Rate.Major Difference between Discounting and Capitalizing 25Gordon Growth Model 25Combining Discounting and Capitalizing (Two-stage Model).Equivalency of Discounting and Capitalizing Models.Midyear Convention.Converting from After-tax Rate to Pretax Rate.Summary.5. Relationship between Risk and the Cost of Capital.Defining Risk.Types of Risk.How Risk Impacts the Cost of Capital.Cost of Equity Capital.Cost of Conventional Debt and Preferred Equity Capital.Cost of Overall Invested Capital.Summary.6. Cost Components of a Company's Capital Structure.Debt.Preferred Equity.Convertible Debt or Preferred Stock.Common Stock or Partnership Interests.Summary.7. Weighted Average Cost of Capital.When to Use Weighted Average Cost of Capital.Weighted Average Cost of Capital Formula.Computing WACC for a Public Company.Computing WACC for a Private Company.Should an Actual or a Hypothetical Capital Structure Be Used? Summary.Part II: Estimating the Cost of Equity Capital.8. Build-up Models.Formula for the Equity Cost of Capital Build-up Model.Risk-free Rate.Equity Risk Premium.Small Stock Premium.Company-specific Risk Premium.Example of a Build-up Model.Summary.9. Capital Asset Pricing Model.Concept of Systematic Risk.Background of the Capital Asset Pricing Model.Systematic and Unsystematic Risk.Using Beta to Estimate Expected Rate of Return.Expanding CAPM to Incorporate Size Premium and Specific Risk.Expanded CAPM Cost of Capital Formula.Assumptions Underlying the Capital Asset Pricing Model.Recent Research on the Equity Risk Premium.Summary.10. Proper Use of Betas.Estimation of Beta.Differences in Estimation of Beta.Levered and Unlevered Betas.Modified Betas: Shrunk and Lagged.Summary.11. Size Effect.Ibbotson Associates Studies.Standard & Poor's Corporate Value Consulting Studies(formerly the PricewaterhouseCoopers Studies).Extension of Data to Smaller Size Categories:Results from the Pratt's StatsA' Database.Summary.12. DCF Method of Estimating Cost of Capital.Theory of the DCF Method.Mechanics of the DCF Method.Single-stage DCF Model.Multistage DCF Models.Sources of Information.Summary.13. Using Ibbotson Associates Cost of Capital Data (Michael W. Barad and Tara McDowell).Stocks, Bonds, Bills and Inflation.Cost of Capital Yearbook.Ibbotson Beta Book.Cost of Capital Center.14. Arbitrage Pricing Model.Explanation of the APT Model.APM Formula.Summary.Part III: Other Topics Related to Cost of Capital.15. Minority versus Control Implications of Cost of Capital Data.Minority versus Control Has Little or No Impact onCost of Capital.Company Efficiency versus Shareholder Exploitation.Impact of the Standard of Value.Under What Circumstances Should a Control PremiumBe Applied? A Tale of Two Markets.Many Takeovers at Less Than Public Trading Price.Summary.16. Handling the Discount for Lack of Marketability.Discrete Percentage Discount for Lack of Marketability.Building the Discount for Lack of Marketability into theDiscount Rate.Summary.17. How Cost of Capital Relates to the Excess EarningsMethod of Valuation.Basic AExcess EarningsA Valuation Method.Cost of Capital Reasonableness Check.Vagaries of the Excess Earnings Method.Summary.18. Common Errors in Estimation and Use of Cost of Capital.Confusing Discount Rates with Capitalization Rates.Using the Firm's Cost of Capital to Evaluate a More or LessRisky Acquisition or Project.Mistaking Historical Rates of Return for Expected Rates ofReturn.Mismatching the Discount Rate with the Economic IncomeMeasure.Performing an Excess Earnings Method Valuation That Resultsin an Unrealistic Cost of Capital.Projecting Growth beyond That Which the Capital BeingValued Will Support.Internally Inconsistent Capital Structure Projection.Assumptions That Produce a Standard of Value Other ThanThat Specified in the Valuation Engagement.Incorrect or Inadequately Supported Data in Estimating theCost of Equity.Summary.19. Cost of Capital in the Courts.Cost of Capital in Shareholder Disputes.Cost of Capital in the Tax Court.Cost of Capital in Family Law.Cost of Capital in Bankruptcy Reorganizations.Cost of Capital Included in Damages.Cost of Capital in Utility Rate-setting.Taxicab Lease Rates.Summary.20. Cost of Capital in Ad Valorem Taxation (Carl R.E. Hoemke).Introduction to Ad Valorem Taxation.Some Examples of Law That Promulgates the Definition ofIncome to Discount.General Categories of Legislative Constraints WhereAdjustments to the Cost of Capital Are Necessary.Cost of Capital in a Constant, Perpetual Cash Flow Scenario.Different Types of Adjustments.Other Adjustments to the Cost of Capital.Summary.21. Capital Budgeting and Feasibility Studies.Invest for Returns above Cost of Capital.DCF Is Best Corporate Decision Model.Focus on Net Cash Flow.Adjusted Present Value Analysis.Use Target Cost of Capital over Life of Project.Summary.22. Central Role of Cost of Capital in Economic Value Added (Joel M. Stern, G. Bennett Stewart III, and Donald H. Chew Jr.).EVA Financial Management System.EVA and the Corporate Reward System.Summary.Appendixes.Appendix A: Bibliography.Appendix B: Courses and Conferences.Appendix C: Data Resources.Appendix D: Developing Cost of Capital (Capitalization Ratesand Discount Rates) Using ValuSource PROSoftware (Z. Christopher Mercer, ASA, CFA).Appendix E: Iterative Process Using CAPM to Calculate theCost of Equity Component of the WeightedAverage Cost of Capital (Harold G. Martin, Jr., MBA, CPA/ABV, ASA, CFE).Appendix F: International Glossary of Business Valuation Terms.Appendix G: Converting After-tax Discount Rates to PretaxDiscount Rates.CPE Self-study Examination.Index.

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