Chapter 6

Cost of Capital/Rates of Return

This chapter focuses on the cost of capital or rates of return for equity and for invested capital (which includes interest-bearing debt). Both of these are explicitly used in the income approach through the application of discount and capitalization (cap) rates to an appropriate economic benefit stream. These same concepts are also implicitly used via price earnings (P/E) multiples in the market approach because a P/E multiple is the reciprocal of an earnings capitalization rate applicable to earnings under the income approach. These sources of cost of capital will be discussed here. Addendum 1 to this chapter contains three articles that analyze each component of the cost of capital in great detail. On the website www.wiley.com/go/FVAM3E, there are seven additional addendums to this chapter. Addendum 2 is an article from Financial Valuation and Litigation Expert (FVLE) on Ibbotson industry risk premiums. Addendum 3 is an article from FVLE on total betas, and Addendum 4 is an article from FVLE on cost of equity capital. Addenda 5 and 6 explain Duff & Phelps, LLC 2009 and 2010 Risk Premium Reports. Addendum 7 presents the Risk Rate Component Model. Addendum 8 is an update article from FVLE on cost of equity.

THREE VARIABLES

In the income approach, the value of the company is a function of three variables:

1. The economic benefit stream, typically cash flow

2. The growth potential of the company being valued, both short- and long-term ...

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