Business Valuation

CHAPTER 7Cost of Capital Concepts

PYRAMID STEP 7 Evaluate cost of capital models and data.

A key input in the valuation process is the risk tied to the identified benefit stream. In other words, what is the risk of not achieving it? In valuation, this risk is generally referred to as the “cost of capital,” or the amount of annual return an investor demands to be enticed to invest in a specific business venture or investment. Once the levels of risk embedded in the selected benefit stream have been identified, the analyst can choose an appropriate cost of capital model and quantify the relevant inputs to match the risk inherent in the benefit stream.

Learning Objectives

By the end of this chapter, readers should be able to:

• Define the cost of capital.
• Determine the difference between the cost of equity and the cost of invested capital.
• Identify the risk factors affecting the cost of capital.
• Articulate the difference between discount rates and capitalization rates.
• Select from the more commonly used cost of capital models based on the purpose of the assignment.
• Select from the more commonly used cost of capital data sources.
• Articulate the strengths and weaknesses of less frequently used cost of capital models.
• Recognize common pitfalls and errors in applying the income approach, such as mismatched inputs (e.g., using an equity cash flow with a weighted average cost of ...