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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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CHAPTER 1

The Cost Of Capital

The weighted average cost of capital (WACC) is a critical input for evaluating investment decisions: It is typically the discount rate for net present value (NPV) calculations. And it serves as the benchmark for operating performance, relative to the opportunity cost of capital employed to create value.

Though the Capital Asset Pricing Model (CAPM) has been challenged, it remains the most practical approach to determine a cost of equity. In fact, many perceived limitations arise from challenges in applying the model. We will provide suggestions to deal with the primary difficulties in applying the CAPM: (1) estimating the market risk premium (MRP) for equities; (2) measuring the systematic risk, or beta, of a company; (3) normalizing the riskless rate; (4) estimating an appropriate cost of debt; and (5) estimating global capital costs. Finally, we will also address the related issue of corporate hurdle rates for investment.

The cost of capital is an estimation that should be applied with care to avoid any illusions of false precision. Despite its many degrees of freedom, financial planning time and resources are often better allocated to other areas, such as value creation and risk management. Ultimately, it is the business case, quality of cash flow forecasts, sensitivity analysis, and strategic risk management that will have the greatest impact on value creation.

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