Best Practices in Estimating the Cost of Capital: An Update
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 estimation to identify current best practices that emerge. Unlike many broadly distributed multiple
- A corporate survey participant converged into compelling recommendations about the cost of capital to a corporation. By the early 1990s, a consensus had emerged prompting descriptions such as “traditional... textbook...appropriate,” “theoretically correct,” “a useful rule of thumb” and a “good vehicle.” In prior work with
on conversations with practitioners at highly regarded on advice from best-selling textbooks and trade books. common theoretical frameworks to estimate the cost of variation, however, for the joint choices of the risk-free rate of return, beta and the equity market risk premium, as well
of implementation.1 study. We revisit the issues and see what now constitutes best practice and what has changed in both academic recommendations and in practice.
practice has changed some since the late 1990s but there is still no consensus on important practical issues. The paper ends with a synthesis of messages from best practice
capital costs. This evidence is valuable in several respects. application of cost of capital theory, setting the stage for productive debate and research on their
15
“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 estimation to identify current best practices that emerge. Unlike many broadly distributed multiple
- A corporate survey participant converged into compelling recommendations about the cost of capital to a corporation. By the early 1990s, a consensus had emerged prompting descriptions such as “traditional... textbook...appropriate,” “theoretically correct,” “a useful rule of thumb” and a “good vehicle.” In prior work with
on conversations with practitioners at highly regarded on advice from best-selling textbooks and trade books. common theoretical frameworks to estimate the cost of variation, however, for the joint choices of the risk-free rate of return, beta and the equity market risk premium, as well
of implementation.1 study. We revisit the issues and see what now constitutes best practice and what has changed in both academic recommendations and in practice.
practice has changed some since the late 1990s but there is still no consensus on important practical issues. The paper ends with a synthesis of messages from best practice
capital costs. This evidence is valuable in several respects. application of cost of capital theory, setting the stage for productive debate and research on their
References: Association for Finance Professionals, 2011, “Current Trends in Estimating and Applying the Cost of Capital: Report of Survey Results,” www. Banz, R., 1981, “The Relationship between Return and Market Value of Common Stock,” Journal of Financial Economics Barra, 2007, Barra Risk Model Handbook, MSCI Barra, www.Barra.com/ support/library. Fernandez, P., J. Aguirreamalloa, and L. Corres, 2011, “US Market Risk Premium used in 2011 by Professors, Analysts and Companies: A Brealey, R., S. Myers, and F. Allen, 2011, Principles of Corporate Finance, Harris, R Brigham, E. and M. Ehrhardt, 2013, Financial Management: Theory and Practice, 14th ed., Mason, OH, South-Western Publishing. Harris, R. and F. Marston, 2013, “Changes in the Market Risk Premium and the Cost of Capital: Implications for Practice,” Journal of Applied Bruner, R., K. Eades, R. Harris, and R. Higgins, 1998, “Best Practices in Estimating the Cost of Capital: Survey and Synthesis,” Financial Burns, R. and J. Walker, 2009, “Capital Budgeting Surveys: The Future is Now,” Journal of Applied Finance 19 (No Higgins, R.C., 2012, Analysis for Financial Management, 10th Ed., New Ibbotson, SBBI, 2012, Classic Yearbook, Market Results for Stocks, Bonds, Jacobs, M.T. and A. Shivdasani, 2012, “Do You Know Your Cost of Capital?” Harvard Business Review (July). Conroy, R. and R. Harris, 2011, “Estimating Capital Costs: Practical Implementation of Theory’s Insights” Capital Structure and Financing Dimson, E., P. Marsh, and M. Staunton, 2011b, The Dimson-MarshStaunton Global Investment Returns Database (the “DMS Database”), New York, NY, Morningstar Inc. Fama, E.F. and K.R. French, 1992, “The Cross-section of Expected Returns,” Journal of Finance