Best Practices in Estimating the Cost of Capital: An Update

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BROTHERSON ET AL. – “BEST PRACTICES” IN ESTIMATING THE COST OF CAPITAL: AN UPDATE

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“Best Practices” in Estimating the Cost of Capital: An Update
W. Todd Brotherson, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins

“Cost of capital is so critical to things we do, and CAPM has so many holes in it—and the books don’t tell you which numbers to use… so at the end of the day, you wonder a bit if you’ve got a solid number. Am I fooling myself with this

Theories on cost of capital have been around for decades.
Unfortunately for practice, the academic discussions typically stop at a high level of generality, leaving important questions

This paper updates our earlier work on the state of the art in cost of capital
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For instance, Jacobs and
Shivdasani (2012) provide useful insights based on the
Association for Finance Professionals (AFP) cost of capital survey. While the survey had 309 respondents, AFP (2011, page 18) reports this was a response rate of about 7% based on its membership companies. In contrast, we report the result of personal telephone interviews with practitioners from a carefully chosen group of leading corporations and

theory is silent or ambiguous and practitioners are left to their own devices.
The following section gives a brief overview of the weighted-average cost of capital. The research approach and sample selection are discussed in Section II. Section III reports the general survey results. Key points of disparity are reviewed in Section IV. Section V discusses further survey results on risk adjustment to a baseline cost of capital, and
Section VI highlights some institutional and market forces affecting cost of capital estimation. Section VII offers

(1)

where:
K = component cost of capital.
W = weight of each component as percent of total capital. t = marginal corporate tax rate.
For simplicity, this formula includes only two sources of capital; it can be easily expanded to include other sources as well.
Finance theory offers
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