Cost of Capital: Applications and Examples / Edition 4

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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 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Cost of Capital summarizes the results and practical implications of the latest research—much of which is gleaned from unpublished academic working papers—and includes scores of formulas and elucidating examples throughout to enhance readers' insights.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: 9780470476055
  • Publisher: Wiley
  • Publication date: 10/19/2010
  • Series: Wiley Finance Series , #604
  • Edition description: Older Edition
  • Edition number: 4
  • Pages: 704
  • Product dimensions: 7.40 (w) x 10.10 (h) x 1.90 (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




Notation System and Abbreviations Used in This Book

PART ONE Cost of Capital Basics

Chapter 1 Defining Cost of Capital 3

Chapter 2 Introduction to Cost of Capital Applications: Valuation and Project Selection 10

Chapter 3 Net Cash Flow: Preferred Measure of Economic Income 16

Chapter 4 Discounting versus Capitalizing 26

Chapter 5 Relationship between Risk and the Cost of Capital 45

Chapter 6 Cost Components of a Business's Capital Structure 61

PART TWO Estimating the Cost of Equity Capital and the Overall Cost of Capital

Chapter 7 Build-up Method 87

Chapter 8 Capital Asset Pricing Model 103

Chapter 9 Equity Risk Premium 115

Appendix 9A Realized Risk Premium Approach and Other Sources of ERP Estimates 146

Chapter 10 Beta: Differing Definitions and Estimates 159

Chapter 11 Unlevering and Levering Equity Betas 185

Chapter 12 Criticism of CAPM and Beta versus Other Risk Measures 208

Chapter 13 Size Effect 232

Chapter 14 Criticisms of the Size Effect 262

Appendix 14A Other Data Issues Regarding the Size Effect 279

Chapter 15 Company-specific Risk 287

Chapter 16 Distressed Businesses 313

Chapter 17 Other Methods of Estimating the Cost of Equity Capital 347

Chapter 18 Weighted Average Cost of Capital 369

Chapter 19 Global Cost of Capital Models 403

Chapter 20 Using Morningstar Cost of Capital Data 428

PART THREE Corporate Finance Officers: Using Cost of Capital Data

Chapter 21 Capital Budgeting and Feasibility Studies 461

Chapter 22 Cost of Capital for Divisions and Reporting Units 468

Chapter 23 Cost of Capital for Fair Value Reporting of Intangible Assets 497

Chapter 24 Cost of Capital in Evaluating Mergers and Acquisitions 518

Chapter 25 Cost of Capital in Transfer Pricing 531

Chapter 26 Central Role of Cost of Capital in Economic Value Added 558

PART FOUR Other Cost of Capital Considerations

Chapter 27 Handling Discounts for Lack of Marketability and Liquidity for Minority Interests in Operating Businesses 571

Chapter 28 The Private Company Discount for Operating Businesses 587

Chapter 29 Cost of Capital of Interests in Pass-through Entities 597

Chapter 30 Relationship between Risk and Returns in Venture Capital and Private Equity Investments 611

Chapter 31 Minority versus Control Implications of Cost of Capital Data 624

Chapter 32 How Cost of Capital Relates to the Excess Earnings Method of Valuation 634

Chapter 33 Adjusting the Discount Rate to Alternative Economic Measures 642

Chapter 34 Estimating Net Cash Flows 647

PART FIVE Advice to Practitioners

Chapter 35 Common Errors in Estimation and Use of Cost of Capital 669

Chapter 36 Dealing with Cost of Capital Issues 684

Appendix I Bibliography 697

Appendix II Data Resources 725

Appendix III International Glossary of Business Valuation Terms 738

Index 747

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