Cost of Capital: Applications and Examples

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Cost of capital estimation has long been recognized as one of the most critical elements in business valuation, capital budgeting, feasibility studies, and corporate finance decisions and is also the most difficult procedure to assess and perform. Now in its fourth edition, Cost of Capital: Applications and Examples addresses the most controversial issues and problems in estimating the cost of capital.

Renowned valuation experts and authors Shannon Pratt and Roger Grabowski ...

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Overview

Cost of capital estimation has long been recognized as one of the most critical elements in business valuation, capital budgeting, feasibility studies, and corporate finance decisions and is also the most difficult procedure to assess and perform. Now in its fourth edition, Cost of Capital: Applications and Examples addresses the most controversial issues and problems in estimating the cost of capital.

Renowned valuation experts and authors Shannon Pratt and Roger Grabowski present both the theoretical development of cost of capital estimation and its practical application to valuation, capital budgeting, and forecasting of expected investment returns encountered in current practice. In this learning text/handy reference, Pratt and Grabowski deftly review and explore the theory of what drives—the cost of capital, the models currently in use to estimate cost of capital, and the data available as inputs to the models to estimate cost of capital.

In this thoroughly updated and comprehensive fourth edition, Cost of Capital summarizes the results and practical implications of the latest research—much of which is gleaned from unpublished academic working papers—and includes scores of formulas and elucidating examples throughout to enhance readers' insights.

Pratt and Grabowski have updated their text to include a host of new material, including:

  • A new chapter reconciling various forms of the income approach
  • Expanded material on estimating the equity risk premium, chronicling the impact of the crisis of 2008–2010 and its impact on the cost of equity capital
  • Expanded material on estimating the cost of debt capital and the impact of deleveraging on the debt capacity of businesses
  • An updated chapter covering cost of capital for financial reporting under SFAS 141R, 142, and 144 (with full cross-referencing to the new FASB Accounting Codification), with examples of inferring rates of return for underlying assets from cost of capital of reporting units
  • Expanded chapters on risk measures and their relationship to cost of capital and company-specific risk
  • Expanded chapters on cost of capital for distressed companies
  • Expanded discussions on the Morningstar SBBI data on supply-side equity risk premium and size premium
  • Updated chapter on the cost of capital in transfer pricing related to the valuation of intangible assets under the new cost-sharing regulations

The landmark book corporate treasurers, business appraisers, CPAs, and valuation experts have come to rely on, Cost of Capital lays out the basic tools to use immediately when estimating cost of capital or when reviewing an estimate. This dynamic author team also analyzes criticism of major models for developing estimates of the cost of capital in use today, and also presents procedures for a number of alternative models.

This definitive text is an indispensable reference tool for professional valuation practitioners as well as attorneys and judges, investment bankers, CFOs, academicians and students, and CPAs.

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Product Details

  • ISBN-13: 9780470171158
  • Publisher: Wiley, John & Sons, Incorporated
  • Publication date: 4/4/2008
  • Edition number: 3
  • Pages: 816
  • Product dimensions: 7.34 (w) x 10.04 (h) x 1.77 (d)

Meet the Author

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.

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.

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Table of Contents

About the Authors     xi
Foreword     xvii
Preface     xix
Acknowledgments     xxiii
Introduction     xxv
Notation System and Abbreviations Used in This Book     xxix
Cost of Capital Basics     1
Defining Cost of Capital     3
Introduction to Cost of Capital Applications: Valuation and Project Selection     9
Net Cash Flow: Preferred Measure of Economic Income     15
Discounting versus Capitalizing     23
Relationship between Risk and the Cost of Capital     39
FASB's Concepts Statement No. 7: Cash Flows and Present Value Discount Rates     48
Cost Components of a Company's Capital Structure     51
Estimating the Cost of Equity Capital and the Overall Cost of Capital     67
Build-up Method     69
Capital Asset Pricing Model     79
Equity Risk Premium     89
Bias Issues in Compounding and Discounting     114
Beta: Differing Definitions and Estimates     117
Formulas and Examples for Unlevering and Levering Equity Betas     143
Examples of Computing OLS Beta, Sum Beta, and Full-Information Beta Estimates     151
Criticism of CAPM and Beta versus Other Risk Measures     161
Example of Computing Downside Beta Estimates     176
Size Effect     179
Criticisms of the Size Effect     209
Other Data Issues Regarding the Size Effect     220
Company-Specific Risk     225
Alternative Cost of Equity Capital Models     243
Implied Cost of Equity Capital     255
Weighted Average Cost of Capital     265
Iterative Process Using CAPM to Calculate the Cost of Equity Component of the Weighted Average Cost of Capital When Capital Structure Is Constant     283
Iterative Process Using CAPM to Calculate the Cost of Equity Component of the Weighted Average Cost of Capital When Capital Structure Is Changing     297
Global Cost of Capital Models     309
Using Morningstar Cost of Capital Data     331
Corporate Finance Officers: Using Cost of Capital Data     361
Capital Budgeting and Feasibility Studies     363
Cost of Capital for Divisions and Reporting Units     369
Cost of Capital in Evaluating Acquisitions and Mergers     385
Cost of Capital in Transfer Pricing     393
Central Role of Cost of Capital in Economic Value Added     409
Cost of Capital for Closely Held Entities     417
Handling the Discount for Lack of Marketability for Operating Businesses     419
Private Company Discount     429
Cost of Capital of Interests in Pass-Through Entities     437
Cost of Capital in Private Investment Companies     449
Relationship between Risk and Returns in Venture Capital Investments     469
Other Topics     479
Minority versus Control Implications of Cost of Capital Data     481
How Cost of Capital Relates to the Excess Earnings Method of Valuation     493
Adjusting the Discount Rate to Alternative Economic Measures     501
Estimating Net Cash Flows     505
Estimating the Value of a Firm in Financial Distress     518
Common Errors in Estimation and Use of Cost of Capital     529
Cost of Capital in the Courts     539
Real Estate and Ad Valorem     559
Cost of Capital of Real Property-Individual Assets     561
Valuing Real Property     580
Cost of Capital of Real Estate Entities     587
Valuing Real Estate Entities     615
Cost of Capital in Ad Valorem Taxation     623
Advice to Practitioners     639
Dealing with Cost of Capital Issues     641
Questions to Ask Business Valuation Experts     647
Appendices      653
Bibliography     655
Data Resources     683
International Glossary of Business Valuation Terms     693
Sample Report Submitted to U.S. Tax Court   Roger J. Grabowski     703
ValuSource Valuation Software     725
Review of Statistical Analysis     733
Index     771

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