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Cost of Capital: Applications and Examples, 5th Edition

ISBN: 978-1-118-85282-8
1344 pages
March 2014
Cost of Capital: Applications and Examples, 5th Edition (1118852826) cover image


A one-stop shop for background and current thinking on the development and uses of rates of return on capital

Completely revised for this highly anticipated fifth edition, Cost of Capital contains expanded materials on estimating the basic building blocks of the cost of equity capital, the risk-free rate, and equity risk premium. There is also discussion of the volatility created by the financial crisis in 2008, the subsequent recession and uncertain recovery, and how those events have fundamentally changed how we need to interpret the inputs to the models we use to develop these estimates.

The book includes new case studies providing comprehensive discussion of cost of capital estimates for valuing a business and damages calculations for small and medium-sized businesses, cross-referenced to the chapters covering the theory and data.

  • Addresses equity risk premium and the risk-free rate, including the impact of Federal Reserve actions
  • Explores how to use Morningstar's Ibbotson and Duff Phelps Risk Premium Report data
  • Discusses the global cost of capital estimation, including a new size study of European countries

Cost of Capital, Fifth Edition puts an emphasis on practical application. To that end, this updated edition provides readers with exclusive access to a companion website filled with supplementary materials, allowing you to continue to learn in a hands-on fashion long after closing the book.

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Table of Contents

About the Authors xiii

Foreword xxiii

Preface xxv

Acknowledgments xxix

PART ONE Cost of Capital Basics 1

CHAPTER 1 Defining Cost of Capital 3

CHAPTER 2 Introduction to Cost of Capital Applications: Valuation, Project Selection, and Ratemaking 11

CHAPTER 3 Net Cash Flow: The Preferred Measure of Economic Income 17

APPENDIX 3A Alternative Measures of Economic Income 30

CHAPTER 4 Discounting versus Capitalizing 36

APPENDIX 4A Equivalency of Capitalizing Residual Income 56

CHAPTER 5 Discounting—Beyond the Basics 60

CHAPTER 6 Relationship between Risk and the Cost of Capital 70

PART TWO Estimating the Cost of Equity Capital 89

CHAPTER 7 Risk-free Rate 91

CHAPTER 8 Equity Risk Premium 110

APPENDIX 8A Deriving ERP Estimates 141

APPENDIX 8B Other Sources of ERP Estimates 173

CHAPTER 9 Build-up Method 177

CHAPTER 10 Capital Asset Pricing Model 189

CHAPTER 11 Beta: Differing Definitions and Estimates 202

APPENDIX 11A Examples of Computing OLS Beta, Sum Beta, and Full-information Beta Estimates 225

APPENDIX 11B Estimating Beta: Interpreting Regression Statistics 234

CHAPTER 12 Unlevering and Levering Equity Betas 243

CHAPTER 13 Criticism of CAPM and Beta versus Other Risk Measures 269

APPENDIX 13A Example of Computing Downside Beta Estimates 298

CHAPTER 14 Size Effect 301

CHAPTER 15 Criticisms of the Size Effect 331

APPENDIX 15A Other Data Issues Regarding the Size Effect 363

CHAPTER 16 Company-specific Risk 372

CHAPTER 17 Distressed Businesses 400

APPENDIX 17A Cost of Capital and the Valuation of Worthless Stock 428

CHAPTER 18 Other Methods of Estimating the Cost of Equity Capital 444

CHAPTER 19 Using the Duff & Phelps Risk Premium Report Data 471

APPENDIX 19A Examples Using the Duff & Phelps Risk Premium Report Data 499

PART THREE Estimating the Overall Cost of Capital 519

CHAPTER 20 Other Components of a Business's Capital Structure 521

CHAPTER 21 Weighted Average Cost of Capital 544

APPENDIX 21A Iterative Process Using CAPM to Calculate the Cost of Equity Component of the Weighted Average Cost of Capital 576

PART FOUR Estimating the Cost of Capital—Non-Freely Traded Interests 609

CHAPTER 22 Handling Discounts for Lack of Marketability and Liquidity for Minority Interests in Operating Businesses 611

CHAPTER 23 Cost of Capital of Family Holding Company Interests 630

CHAPTER 24 The Private Company Discount for Operating Businesses 650

CHAPTER 25 Cost of Capital of Interests in Pass-through Entities 663

CHAPTER 26 Relationship between Risk and Returns in Venture Capital and Private Equity Investments 680

CHAPTER 27 Cost of Capital for Closely Held Businesses 693

PART FIVE Corporate Finance Officers: Using Cost of Capital Data 711

CHAPTER 28 Capital Budgeting and Feasibility Studies 713

CHAPTER 29 Cost of Capital for Divisions and Reporting Units 722

CHAPTER 30 Cost of Capital for Fair Value Reporting of Intangible Assets 757

CHAPTER 31 Cost of Capital in Evaluating Mergers and Acquisitions 779

CHAPTER 32 Cost of Capital in Transfer Pricing 793

APPENDIX 32A Cost of Capital in Transfer Pricing Example 822

CHAPTER 33 The Role of the Cost of Capital in EVA and in Corporate Value-Based Management 825

PART SIX Other Cost of Capital Considerations 839

CHAPTER 34 Estimating Economic Income 841

CHAPTER 35 Minority versus Control Implications of Cost of Capital Data 861

CHAPTER 36 How Cost of Capital Relates to the Excess Earnings Method of Valuation 873

CHAPTER 37 Adjusting the Discount Rate to Alternative Economic Income Measures 881

PART SEVEN Considerations in Special Applications 897

CHAPTER 38 How Courts View Cost of Capital 899

CHAPTER 39 Global Cost of Capital Models 1011

CHAPTER 40 Cost of Capital of Real Property—Individual Assets 1052

APPENDIX 40A Valuing Real Property 1076

CHAPTER 41 Cost of Capital of Real Estate Entities 1084

APPENDIX 41A Valuing Real Estate Entities 1122

PART EIGHT Case Studies 1129

CHAPTER 42 Cost of Capital for a Mid-Sized Company 1131

APPENDIX 42A Report for Cost of Capital for a Mid-Sized Company 1138

CHAPTER 43 Cost of Capital for a Smaller-Sized Company 1162

APPENDIX 43A Report for Cost of Capital for a Smaller-Sized Company 1168

PART NINE Advice to Practitioners 1179

CHAPTER 44 Common Errors in Estimation and Use of Cost of Capital 1181

CHAPTER 45 Advice on Dealing with Cost of Capital Issues 1199

APPENDIX I Bibliography 1213

APPENDIX II Data Resources 1239

APPENDIX III Glossary of Cost of Capital Terms 1253

About the Website 1266

Index of Cases 1267

Index 1271

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Author Information

Shannon P. Pratt, CFA, FASA, ARM, MCBA, CM&AA, referred to as the father of business valuations, is the author of several bestselling Wiley business valuation books and a sought-after speaker at business valuation industry conferences. He is the managing owner of Shannon Pratt Valuations, Inc., and has served as supervisory analyst for over 3,000 business valuation engagements in forty years and as an expert witness in numerous state and federal courts on contested business valuations. Dr. Pratt is co-author of the upcoming Lawyer’s Guide to Cost of Capital.

Roger J. Grabowski is managing director of Duff & Phelps LLC. Roger has testified in court as an expert witness on the value of closely held businesses and business interests, matters of solvency, valuation, and amortization of intangible assets, and other valuation issues. He testified in the Northern Trust case, the first U.S. Tax Court decision that adopted the discounted cash flow method to value the stock of a closely held business with the discount rate based on the capital asset pricing model. Grabowski authors the annual Duff & Phelps Risk Premium Report and is co-author of the upcoming 2014 Valuation Handbook:Guide to Cost of Capital and co-author of the upcoming Lawyer’s Guide to Cost of Capital.

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