Chapter 9

Estimating the Cost of Capital*

Joseph J. Galanti

9.1 Introduction

Cash flow analyses in the context of damages calculations or business valuations need to consider the time value of money. One can measure an asset's value by its ability to generate cash flows. Analysts should discount future cash flows from investments, projects, businesses, or damages awards to the present to calculate current values. This chapter focuses on the theoretical basis of the rate used for that discounting, including the opportunity cost of capital, the underlying factors affecting the rate, and methods used to estimate it. Identifying an appropriate discount rate is as important as estimating the related future cash flows to arrive at a proper valuation.

Section 9.2 reviews the concept of opportunity cost of capital and identifies the risks relevant to cost of capital estimation; Section 9.3 presents the theoretical models that courts and practitioners use in estimating the cost of equity capital; and Section 9.4 contains example applications of two of the most common methods used to calculate the cost of capital: the capital asset pricing model (CAPM) and the build-up method.

9.2 Opportunity Cost of Capital

The cost of capital is the rate of return required by investors (both bondholders and equity holders) for them to supply capital. One can view it as an opportunity cost because the rate must equal or exceed what the investor could obtain from a similar investment of comparable risk. ...

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