The Cost of Capital
As discussed, we view obtaining precision in the estimated cost of equity or WACC as practically insoluble and of more use as a theoretical construct. This is not to say we do not want some bounding of the discount rate. However, we strongly believe that we cannot choose a discount rate without considering the decision context and the degree to which we have incorporated uncertainty in the measure we are discounting. In addition, consider some of the practical issues with each of the key components of traditional measures of the cost of capital.1
20.1 RISK-FREE RATE
The typical risk-free rate people start with is a liquid government bond of a medium- to long-term duration. Therefore, in the US we often saw people using 30-year Treasuries until the market shifted to the 10-year bond being the most liquid. When we do global research, especially in markets where local government bond markets are underdeveloped or where the local government bonds are risky, then we have a problem. But this is not the only issue.
Why are we using a single rate rather than a yield curve? If a company earns a significant portion of its wealth creation in the next 3 years, say from a blockbuster product, do we really want to discount these values (residual income, dividend or cash flow) using a long-duration bond rate? Furthermore, a portfolio manager has to make a decision about where to invest the funds “today”, so the benchmark alternative can be a short-term yield. There are ...