Cost of Capital

In a world of constant change and progress, it is sometimes easy to forget the details. With costs, prices, and profits fluctuating constantly, it is crucial to stay up-to-date on financial accounting procedures and techniques. And with the U.S. generating over $500 billion in capital spending each year, outdated estimations could sway the costs by a few percentage points, but essentially sway the total by billions.

This article attempts to exploit the different types of estimations by conducting phone surveys and interviewing many different types of companies. Out of 74 Fortune 100 companies surveyed, all said they used some form of discounting when it came to their capital budgeting and 93% said they used a weighted-average cost of capital. However, a smaller percentage of Fortune 500 large companies and Forbes best small companies said they used the capital asset pricing model.

The authors then go on to describe the weighted-average cost of capital, the survey findings, the various impacts of assumptions, and conclusions. The weighted-average cost of capital includes many sources, but for simplicity only three are identified; cost of debt, cost of preferred stock, and cost of equity. This formula is able to give the company a general idea of the cost of capital, however the cost of equity is still questionable. After the survey, the researchers realized many similarities across all the different companies surveyed. They all used a form of Discounted Cash Flows, weights are based on market value not book value, and the CAPM (Capital Asset Pricing Model) is the dominant model that should be used for the cost of equity estimation. The CAPM is composed of three separate parts, the risk-free rate, the stock equity’s beta, and the market risk premium. The authors then move on to evaluate the impact of the various assumptions of the CAPM. The researchers used short-term rates, long-term rates, and long-term risk free rates and found that

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