!URL http://hbr.org/2012/07/do-you-know-your-cost-of-capital/ar/1 !Description With trillions of dollars in cash sitting on their balance sheets, corporations have never had so much money. How executives choose to invest that massive amount of capital will drive corporate strategies and determine their companies’ competitiveness for the next decade and beyond. And in the short term, today’s capital budgeting decisions will influence the developed world’s chronic unemployment situation and tepid economic recovery. To estimate their cost of equity, about 90% of the respondents use the capital asset pricing model [[CAPM|Portfolio Theory and the Capital Asset Pricing Model]], which quantifies the return required by an investment on the basis of the associated risk. But that is where the consensus ends. Finance professionals differ in opinion on the underlying assumptions for 6 basic metrics: # The Investment Time Horizon # The Cost of Debt # The Risk-Free Rate # The Equity Market Premium # The Risk of the Company Stock ([[Beta]]) # The Debt-to-Equity Ratio # Project Risk Adjustment !The Investment Time Horizon The miscalculations begin with the forecast periods. Of the AFP survey respondents, 46% estimate an investment’s cash flows over five years, 40% use either a 10- or a 15-year horizon, and the rest select a different trajectory. <<image /static/files/Finance/R1207L_A.gif width:300>> Some differences are to be expected, of course. A pharmaceutical company evaluates an investment in a drug over the expected life of the patent, whereas a software producer uses a much shorter time horizon for its products. In fact, the horizon used within a given company should vary according to the type of project, but we have found that companies tend to use a standard, not a project-specific, time period. In theory, the problem can be mitigated by using the appropriate terminal value: the number ascribed to cash flows beyond the forecast horizon. In practice, the inconsistencies with terminal values are much more egregious than the inconsistencies in investment time horizons, as we will discuss. (See the sidebar [[How to Calculate Terminal Value]]) !The Cost of Debt Having projected an investment’s expected cash flows, a company’s managers must next estimate a rate at which to discount them. This rate is based on the company’s cost of capital, which is the weighted average of the company’s cost of debt and its cost of equity, the [[WACC]]. Estimating the cost of debt should be a no-brainer.But people have different ways of applying a tax rate which can have major implications for the calculated cost of capital. The median effective tax rate for companies on the S&P 500 is 22%, a full 13 percentage points below most companies’ marginal tax rate, typically near 35%. (See the [[The Consequences of Misidentifying the Cost of Capital]]) <<image /static/files/Finance/R1207L_B.gif width:300>> !The Risk-Free Rate Errors really begin to multiply as you calculate the [[Cost of Equity]]. Most managers start with the return that an equity investor would demand on a [[risk-free|Risk free rate of return]] investment. What is the best proxy for such an investment? Most investors, managers, and analysts use U.S. Treasury rates as the benchmark. But that’s apparently all they agree on. * 46% of our survey participants use the 10-year rate, * 12% go for the five-year rate, * 11% prefer the 30-year bond * 16% use the three-month rate. <<image /static/files/Finance/R1207L_C.gif>> The variation is dramatic. When this article was drafted, the 90-day Treasury note yielded 0.05%, the 10-year note yielded 2.25%, and the 30-year yield was more than 100 basis points higher than the 10-year rate. In other words, two companies in similar businesses might well estimate very different costs of equity purely because they don’t choose the same U.S. Treasury rates, not because of any essential difference in their businesses. !The Equity Market Premium The next component in a company’s [[weighted-average cost of capital|WACC]] is the risk premium for equity market exposure, over and above the risk-free return. In theory, the market-risk premium should be the same at any given moment for all investors. That’s because it’s an estimate of how much extra return, over the risk-free rate, investors expect will justify putting money in the stock market as a whole. The estimates, however, are varied. * About half the companies in the AFP survey use a risk premium between 5% and 6% * Some use one lower than 3%, * Others go with a premium greater than 7% <<image /static/files/Finance/R1207L_D.gif>> A huge range of more than 4 percentage points. We have found that companies tend to use a standard, not a project-specific, time period. In theory, the problem can be mitigated by using the appropriate terminal value: the number ascribed to cash flows beyond the forecast horizon. In practice, the inconsistencies with terminal values are much more egregious than the inconsistencies in investment time horizons, as we will discuss. (See [[How to calculate terminal value]]) !The Risk of the Company Stock The final step in calculating a company’s cost of equity is to quantify the [[Beta]], a number that reflects the volatility of the firm’s stock relative to the market. A [[Beta]] greater than 1.0 reflects a company with greater-than-average volatility; a [[Beta]] less than 1.0 corresponds to below-average volatility. Most financial executives understand the concept of [[Beta]], but they can’t agree on the time period over which it should be measured: * 41% look at it over a five-year period * 29% at one year * 15% go for three years * 13% for two. <<image /static/files/Finance/R1207L_E.gif>> Reflecting on the impact of the market meltdown in late 2008 and the corresponding spike in volatility, you see that the measurement period significantly influences the [[Beta]] calculation and, thereby, the final estimate of the cost of equity. For the typical S&P 500 company, these approaches to calculating [[Beta]] show a variance of 0.25, implying that the cost of capital could be misestimated by about 1.5%, on average, owing to [[Beta]] alone. For sectors, such as financials, that were most affected by the 2008 meltdown, the discrepancies in [[Beta]] are much larger and often approach 1.0, implying [[Beta]]-induced errors in the cost of capital that could be as high as 6%. !The Debt-to-Equity Ratio The next step is to estimate the relative proportions of debt and equity that are appropriate to finance a project. Managers are pretty evenly divided among four different ratios: * Current book debt to equity (30% of respondents); * Targeted book debt to equity (28%) * Current market debt to equity (23%) * Current book debt to current market equity (19%). <<image /static/files/Finance/R1207L_F.gif>> Because book values of equity are far removed from their market values, 10-fold differences between debt-to-equity ratios calculated from book and market values are actually typical. !Project Risk Adjustment Finally, after determining the [[weighted-average cost of capital|WACC], which apparently no two companies do the same way, corporate executives need to adjust it to account for the specific risk profile of a given investment or acquisition opportunity. * Nearly 70% do ** half of those correctly look at companies with a business risk that is comparable to the project or acquisition target. * Many companies don’t undertake any such analysis ** instead they simply add a percentage point or more to the rate. An arbitrary adjustment of this kind leaves these companies open to the peril of overinvesting in risky projects (if the adjustment is not high enough) or of passing up good projects (if the adjustment is too high). * 37% of companies surveyed by the AFP made no adjustment at all: They used their company’s own cost of capital to quantify the potential returns on an acquisition or a project with a risk profile different from that of their core business. !Conclusion Disparities in assumptions profoundly influence how efficiently capital is deployed in the US economy.