Best Practices in Estimating the Cost of Capital: Survey and Synthesis

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Overview This case study focuses on where financial theory ends and practical application of the weighted average cost of capital (WACC) begins. It presents evidence on how some of the most financially complex companies and financial advisors estimated capital costs and focuses on the gaps found between theory and application. The approach taken in the paper differed from their predecessors in several various respects. Prior published information was solely based on written, closed-end surveys sent to a large number of firms, without a focused topic. The study set out to see if financial theory, specifically cost-of-capital, is truly ubiquitous in true business applications. The Weighted Average Cost of Capital (WACC) Companies…show more content…
Variations Within the Components of CAPM Their survey results found that there were substantial variations with all three components of the CAPM. • Risk Free Rate of Return In the risk-free rate of return, the choice of the risk-free rate can have an effect on the cost of equity. More specifically, the cost of a short-term stock is typically used to gauge a short-term risk free rate, and typically a long-term stock is used to measure a long-term risk free rate. Since corporate projects are usually long-term projects, companies have a preference in using long-term bond yields. • Beta For beta, there are mainly two different ways to calculate the value for beta. The first is to calculate it yourself based on historical data. By using this method, you run the risk of using inaccurate data if you choose a period that is too broad or narrow. Conversely, the other way to determine it is to use published sources such as Bloomberg and Standard & Poor’s. Similar to using historical data to determine beta, there are variations in these published sources for the values of beta. As a result, the calculation of the overall cost of capital will vary depending on which source of beta you
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