Calculating the Cost of Capital: Issues in Practice

This blog series is going to discuss two distinct issues related to the calculation of the Cost of Capital for a company (its WACC):

  1. Whether the WACC should vary or stay the same throughout a forecast period; and
  2. Whether the Capital Asset Pricing Model is an appropriate tool in measuring WACC, and what other methods are available.

In practice, when building a DCF valuation model of a company in excel, a substantial amount of time is dedicated to financial modeling of forecast operational performance to determine what the relevant cash flows to discount are, but often not as much thought is given to the discount rate to use. This can be a significant issue that impedes an accurate valuation. By the end of this blog, hopefully all current and future students of our Financial Modelling Training Courses will have gained better insight into the importance of getting the discount rate as accurate as possible, and will have some additional tools to help them in this endeavour.

Firstly, what is the Cost of Capital?

Lets step away from mathematical calculations for a second and focus on concepts. In finance theory, the Cost of Capital is the potential rate of return required by investors for them to feel motivated enough to provide a company with their own capital. So to understand the Cost of Capital of a company, an analyst building a DCF valuation model needs to get a handle on the following key issues:

  • What are the potential cash flows on offer from the company?
  • What are the upside and downside risks to the cash flows on offer?
  • How will the marginal investor that is potentially willing and able to invest in the company perceive the cash flows and their potential upside/downside risks?

The first two bullet points are characteristics of the company and its cash flows, while the third bullet point is more about the investor rather than the investment. This relationship between the investor and the investment is often lost on Finance students and Finance Professionals, because the terminology "a company's Cost of Capital" or similar is the most common way of phrasing the concept. What this form misses though is that the Capital belongs to an Investor population that has an attitude that interacts with the performance of the investment. As such the Cost of Capital that the Investors "charge" their Investments is dynamic and subject to change throughout the life of the investment.

Find out more about calculating the cost of capital in our next two posts:
Part 2 &
Part 3

1.      Whether the Capital Asset Pricing Model is an appropriate tool in measuring WACC, and what other methods are available.