Risky business: What factors into the cost of capital?
Valuation experts often use discounted cash flow (DCF) techniques to determine the value of a business or estimate economic losses. A critical input in a DCF model is the cost of capital. This is the rate that’s used to discount future earnings into today’s dollars. Small changes in this rate can have a major impact on the expert’s conclusion, so it’s important to get it right.
Debt vs. equity
The term “cost of capital” refers to the expected rate of return that the market requires to attract funds to a particular investment. The cost of capital is based on the perceived risk of the investment. Risky companies (or investments) warrant a higher discount rate and, therefore, a lower value (and vice versa).
A business can be financed with 100% equity or a blend of equity and debt financing. In general, debt costs less than equity. Why? Debt holders receive regular economic benefits (interest and principal payments). But equity investors receive dividends only at management’s discretion and they must wait until a sale to receive any capital appreciation.
Cost of equity
Several market-based rates can be used to estimate the cost of equity. It typically includes the following components:
- A risk-free rate, based on a U.S. Treasury bond,
- A market risk premium, based on historical returns for a stock index over the risk-free rate, and
- A company-specific risk premium, based on the subject company’s financial performance, industry and other attributes.
The cost of equity is used as the cost of capital when the subject company is financed 100% with equity financing — or when the valuation expert discounts earnings available to only equity investors.
Weighted average cost of capital
When discounting the earnings available to both equity investors and creditors, valuation experts apply a blended rate that incorporates the cost of equity and the cost of debt. This rate is often referred to as the weighted average cost of capital (WACC).
The cost of debt is fairly straightforward: It’s based on the interest rate that banks charge companies for borrowing money. Interest rates have been near historical lows in recent years, so debt can be an inexpensive form of financing. But there are limits to the amount of debt financing creditors will allow, and the cost of debt gradually increases as companies become increasingly leveraged.
In addition, interest payments are generally deductible as a business expense, which further reduces the cost of debt. But, when valuing larger companies, it’s important to factor in limitations on interest expense deductions under current tax law.
When using WACC as the discount rate in a DCF analysis, a valuator can choose various capital structures. What’s appropriate depends on the characteristics of the company and the standard of value being applied.
For example, an expert can apply the subject company’s historical or expected percentages of debt and equity financing. This may be appropriate when valuing a minority interest that lacks the control needed to alter the company’s capital structure.
Alternatively, an expert may choose an industry average capital structure. This is generally more relevant when valuing a controlling interest in the business or when calculating lost profits.
What rate is appropriate?
There’s generally no specific guidance that prescribes a specific discount rate to use when valuing a private business or estimating economic damages. Rather, the appropriate rate is determined on a case-by-case basis, depending on the facts and circumstances. Contact us for more information on this critical issue.