Cost of Capital

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.

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