Recalculating the Cost of Capital

Project valuation is a notoriously imprecise art. “Two of the ubiquitous tools in capital budgeting are a wing and a prayer,” economists Eugene Fama and Kenneth French once famously observed. But by using a new method for calculating the cost of equity capital, financial managers can put valuation decisions on more solid ground.

That's the central claim of a June 2001 article in the Journal of Accounting Research. As co-author Charles M.C. Lee explains, many common methods for calculating the cost of equity, including the venerable capital-asset-pricing model (CAPM), share a significant flaw. The underlying theory focuses on expected returns, an imprecise measure. CAPM, for example, predicts the cost of equity as a function of beta — the relationship between the return that investors expect from a company and the return they expect from the market as a whole.

To gauge expected returns, companies typically rely on historical or realized returns. In principle, that shouldn't matter. If markets are efficient, realized returns over a sufficiently long period should approximate expected returns. But in practice, realized returns turn out to be “a pretty lousy proxy,” Lee says. “You wouldn't have invested in many stocks in the past few years, if you used returns over the last 20, 30 or 40 years to calculate the cost of equity.”

Consequently, Lee and his colleagues suggest that managers look to the future, not the past, for guidance — by using the implied cost of equity to make investment decisions. The implied cost of equity is the internal rate of return that sets a company's market capitalization equal to the present value of all future cash flows to common shareholders. Less technically, i 'st the discount rate that investors implicitly are using to value the business. It's not a new concept. Analysts have long used discounted-cash-flow models. But the authors believe that their study represents the first systematic effort to develop a model that predicts the implied cost of equity.

They begin by calculating the implied cost of equity for more than 1,000 companies between 1979 and 1995. Their analysis reveals that average discount rates vary significantly by industry — a pattern obscured in studies that use realized returns. What's more, which industry a company is in turns out to play a leading role in predicting the company's implied cost of equity.

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