The following paper provides a comprehensive overview of the major debates over estimating the inputs for cost of capital used in the enterprise valuation and corporate valuation. Hundreds of research academics and practitioners over the recent decades have argued concerning methodology used for estimating every single variable in cost of capital. These debates not only made the choices for estimating cost of capital a complex subject, but combined with constantly evolving market characteristics they have made cost of capital and valuation an art.
So far most of practitioners have chosen methods that have been framed by major services, simplicity, data availability, common sense and overall consensus. This paper tries to factor in all of that, in addition, providing a critical opinion at some instances and incorporating major considerations relevant to using cost of capital in the distressed environment.
The objective of the paper is to overview and to compare different methods proposed by various authors and services for estimating elements of cost of capital. The paper aims to analyze as well as conform with or refute widely accepted choices in cost of capital calculations. In the concluding case study we question how the choices of methods lead to varying estimates of cost of equity capital and how that impacts the value of a company.
Contents
1 Introduction
2 Cost of Capital Overview
3 Cost of Equity: Capital Asset Pricing Model
3.1 Risk-free rate
3.2 Beta Estimation
- 3.2.1 Market portfolio
3.2.2 Adjusting for Financial Leverage
3.2.3 Adjusting for Operating Leverage
3.2.4 Adjusting for cash
3.2.5 Modifying beta
3.2.6 Bottom-Up Beta
3.2.7 Debt Beta
4 Equity Risk Premiums
4.1 Market Risk Premium
4.2 Failure of CAPM: additional premiums
- 4.2.1 Small Firm Premium
4.2.2 Illiquidity Premium
4.2.3 Country Risk Premium
4.2.4 Company-specific risk premium
5 Cost of Debt
5.1 Taxes
6 Weighted Average of Cost of Capital
7 Cost of Equity Capital Sensitivity To Beta Estimation Techniques
7.1 Methodology
7.2 Results
7.3 Conclusion
8 Summary and Recommendations
Literature
APPENDIX 1
APPENDIX 2
