Cost of Capital
What’s your real cost of capital?
By James J. McNulty, Tony D. Yeh, William s. Schulze, and Michael H. Lubatkin
Harvard Business Review, October 2002
Issue of the article: valuing investment projects
Number of pages: 12
Daniel Miravet Campos
Part 1. Executive summary This article is fundamentally based on the exposition of a new method to calculate the cost of capital for a company (MCPM), to meet the inefficiencies of the current one (CAPM).
In valuing any investment project or corporate acquisition, executives of a company must compare the cost that operation would require with its expected future cash flows. To do so, they must discount those future cash flows with a specific rate in order to make the comparison meaningful. This is what we know as cost of equity capital, and determining that discount rate is a very important task for the managers of a company, since applying a too high or too low rate will have significant effects on estimating the project’s or company’s value.
The traditional approach to evaluating capital investments is to apply the capital asset pricing model (CAPM), which has remained practically unchanged for 40 years.
This standard formula states that a company’s cost of capital is equal to the risk-free rate of return plus a premium (historical difference between the risk-free rate and the rate of return on the stock market as a whole, measured by an index such as the S&P model multiplied by an adjusting number called “stock’s beta”) to reflect the risk of the investment in question.
But the formula-in particular, its beta element-has long been a source of frustration. In fact, corporate executives and investment bankers routinely fudge their CAPM estimates, because experience and intuition tell them the model produces inappropriate discount rates. CAPM has three main problems: First, beta is a measure of both a stock's correlation and its volatility, which may lead to inaccurate results; the second problem with
By James J. McNulty, Tony D. Yeh, William s. Schulze, and Michael H. Lubatkin
Harvard Business Review, October 2002
Issue of the article: valuing investment projects
Number of pages: 12
Daniel Miravet Campos
Part 1. Executive summary This article is fundamentally based on the exposition of a new method to calculate the cost of capital for a company (MCPM), to meet the inefficiencies of the current one (CAPM).
In valuing any investment project or corporate acquisition, executives of a company must compare the cost that operation would require with its expected future cash flows. To do so, they must discount those future cash flows with a specific rate in order to make the comparison meaningful. This is what we know as cost of equity capital, and determining that discount rate is a very important task for the managers of a company, since applying a too high or too low rate will have significant effects on estimating the project’s or company’s value.
The traditional approach to evaluating capital investments is to apply the capital asset pricing model (CAPM), which has remained practically unchanged for 40 years.
This standard formula states that a company’s cost of capital is equal to the risk-free rate of return plus a premium (historical difference between the risk-free rate and the rate of return on the stock market as a whole, measured by an index such as the S&P model multiplied by an adjusting number called “stock’s beta”) to reflect the risk of the investment in question.
But the formula-in particular, its beta element-has long been a source of frustration. In fact, corporate executives and investment bankers routinely fudge their CAPM estimates, because experience and intuition tell them the model produces inappropriate discount rates. CAPM has three main problems: First, beta is a measure of both a stock's correlation and its volatility, which may lead to inaccurate results; the second problem with