Cost of Capital – Executive Summary
One of the most important parts of the valuation formula is Cost of Capital. Whether you are selling your business, buying a business, or defending the value of your equity interest for tax, ESOP or litigation purposes, the correct value requires the correct determination of the cost of capital and the future cash flows to the equity holder. Unfortunately, many valuations are incorrect due to either a misunderstanding of the approach for calculating the cost of capital or improperly applying the methodology calculating cost of capital. Either way, the result is you have the wrong value that could critically affect your investment, sale or assessment by regulatory bodies.
The most common methodologies used to calculate cost of capital are Capital Asset Pricing Model (CAPM), the Build-up Summation Method, and Weighted Average Cost of Capital (WACC). There are other less frequently used methods that are speculative and/or rejected by regulatory bodies. Avoiding less frequently used methods is advisable. Volume IV – Cost of Capital provides a detailed description of the common methodologies. Due to the complexity of Volume IV, I was encouraged to write this executive summary.
The resources commonly used for determining the cost of capital for privately held companies include Ibbotson Associates Stocks, Bonds, Bills and Inflation (SBBI) Valuation Edition (annual), Duff & Phelps Risk Premium Report (annual), Capital Markets Report (annual) of the Pepperdine Private Capital Markets (PPCM) Project, and Dr. Damodaran’s Equity Risk Premium Study. Other less frequently used resources are available or publicly traded company data is used when public comparables are applicable.
CAPM is used to calculate the cost of equity for publicly traded companies. Modifications of CAPM have been made to apply the methodology to privately held investments; however the underlying assumptions for CAPM are rarely applicable for closely-held businesses.
The Build-up Summation Method is the most common method used by valuation professionals to determine cost of capital. Although the methodology is simply a sum of market risk rates starting with the risk-free rate and adding market risk for size and specific company characteristics, the application varies dramatically from analyst to analyst due to mistakes, bias assumptions, and lack of knowledge and experience. Many arguments have centered on the calculation of cost of capital that delay the transaction or increase the cost of litigation or negotiation that may result in compromise or worst, incorrect conclusions.
Weighted Average Cost of Capital (WACC) calculates the combined cost of debt and equity capital weighted on the market value of debt and equity capital to market value of total invested capital. The method is commonly used by investment bankers and brokers for transactional purposes, which gives proper consideration to the capital structure of the subject entity. WACC is used when applying the private capital market expected returns published by the Pepperdine Capital Market Report. It is reasonable to expect WACC to be the preferred methodology; however, few valuation professionals use this methodology due to complexity and lack of understanding. Not valid reasons for excluding the preferred methodology in market transactions.
Calculating the cost of capital is a science and an art. A science requiring knowledge and experience to properly interpret and utilize and an art requiring a track record of making decisions that are validated with years of accepted conclusions and completed transactions. Let us help you with your valuation needs. We have the track record, knowledge and proprietary tools to determine your cost of capital or help you