Chapter Four

Estimating the Cost of Capital

THE COMPANY'S ESTIMATED COST OF CAPITAL is the fundamental building block for capital allocations—providing analytical consistency across the potential investment alternatives and facilitating comparisons among alternatives that have differing time horizons and risk profiles.

It also provides a basis for comparing reinvestments in the business through capital expenditures or acquisitions versus the return of cash to shareholders through dividends or share repurchases. Unless an investment or acquisition earns the company's cost of capital, shareholders would be better off to receive the cash.

WACC FORMULA

Today most companies estimate their cost of capital through the capital asset pricing model. This model uses a relatively straightforward and well-accepted formula to arrive at an estimate of the company's weighted-average cost of capital (WACC). The variables in this formula can be expressed as follows:

L: The targeted percentage of debt leverage in the company's market capitalization
R: The risk-free rate of interest, typically measured by the 10-year Treasury rate
C: The pre-tax cost of debt, reflecting the company's estimated marginal interest rate for debt financing
M: The market's expectation for equity market returns, typically assumed to be 6 to 7 percentage points over the risk-free rate of interest
B: The company's beta, which is a measure of the correlation of its stock price with the market
T: The company's marginal ...

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