Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 2

Introduction to Cost of Capital Applications: Valuation, Project Selection, and Ratemaking

Introduction

Net Cash Flow Is the Preferred Economic Income Measure

Cost of Capital Is the Proper Discount Rate

Present Value Formula

Example: Valuing a Bond

Applications to Businesses, Business Interests, and Capital Budgeting Projects

Applications in Ratemaking

Summary

INTRODUCTION

Cost of capital has many applications, the two most common being valuation and capital investment project selection. These two applications are very closely related. The basic steps in valuation and investment selection are:

1. Estimation of economic income
2. Estimation of the cost of capital
3. Use of the cost of capital to calculate present values

These steps are applicable to both the discounted cash flow (DCF) and the singleperiod capitalization methods of valuation (see Chapter 4).

This chapter discusses these two applications in very general terms so the reader can quickly understand how a proper estimation of the cost of capital underlies valuations and financial decisions worth billions of dollars every day. Later chapters discuss these applications in more detail.

NET CASH FLOW IS THE PREFERRED ECONOMIC INCOME MEASURE

Throughout this book, we usually assume that the measure of economic income to which the cost of capital will be applied is net cash flow (sometimes called free cash flow). Net cash flow represents discretionary cash available to be paid out to stakeholders (providers of capital) ...