CONTENTS

Cover

Title Page

Dedication

About the Authors

Foreword

Preface

Acknowledgments

Part One: Cost of Capital Basics

Chapter 1: Defining Cost of Capital
1. Introduction
2. Components of a Capital Structure
3. Cost of Capital is a Function of the Investment
4. Cost of Capital is Forward-Looking
5. Cost of Capital is Based on Market Value
6. Cost of Capital is Usually Stated in Nominal Terms
7. Cost of Capital Equals the Discount Rate
8. Discount Rate is Not the Same as Capitalization Rate
9. Standard (Basis) of Value
10. Summary
Chapter 2: Introduction to Cost of Capital Applications: Valuation, Project Selection, and Ratemaking
1. Introduction
2. Net Cash Flow is the Preferred Economic Income Measure
3. Cost of Capital is the Proper Discount Rate
4. Present Value Formula
5. Example: Valuing a Bond
6. Applications to Businesses, Business Interests, and Capital Budgeting Projects
7. Applications in Ratemaking
8. Summary
Chapter 3: Net Cash Flow: The Preferred Measure of Economic Income
1. Introduction
2. Defining Net Cash Flow
3. Net Cash Flows Should be Probability-Weighted Expected Values
4. Why Net Cash Flow is the Preferred Measure of Economic Income
5. Summary
6. Additional Reading
Appendix 3A: Alternative Measures of Economic Income
1. Introduction
2. Capital Cash Flow
3. Adjusted Present Value
4. Residual Income
Chapter 4: Discounting versus Capitalizing
1. Introduction
2. Capitalization Formula
3. Functional Relationship between Discount Rate and Capitalization Rate
4. Major Difference between Discounting and Capitalizing
5. Constant Growth or Gordon Growth Model
6. Criticisms of the Gordon Growth Model
7. Combining Discounting and Capitalizing
8. Equivalency of Discounting and Capitalizing Models
9. Summary
Appendix 4A: Equivalency of Capitalizing Residual Income
Chapter 5: Discounting—Beyond the Basics
1. Introduction
2. Midyear Convention
3. Matching Projection Periods to Financial Statement Dates: Partial First Year
4. Changing Risk Over Time
5. Duration of an Investment
6. Summary
Chapter 6: Relationship between Risk and the Cost of Capital
1. Introduction
2. Defining Risk
3. How Risk Affects the Cost of Capital
4. Types of Risk
5. Measuring Riskiness of Net Cash Flows
6. ASC 820 Fair Value Measurement: Cash Flows and Present Value Discount Rates
7. Summary

Part Two: Estimating the Cost of Equity Capital

Chapter 7: Risk-free Rate
1. Introduction
2. Risk-Free Rate Represented by U.S. Government Securities
3. Why Consider Multiple Maturities?
4. Selecting the Best Risk-Free Maturity
5. Components of the Risk-Free Rate
6. Selecting the Best Risk-Free Yield
7. Summary
Chapter 8: Equity Risk Premium
1. Introduction
2. Defining the Equity Risk Premium
3. Unconditional ERP
4. Conditional ERP
5. Concluding on an ERP
6. Summary
7. Additional Reading
Appendix 8A: Deriving ERP Estimates
1. Realized Risk Premium (Ex Post) Approach
2. Comparing Investor Expectations to Realized Risk Premiums
3. Using the Geometric Average for Compounding and the Arithmetic Average for Discounting
4. Implied Ex ANTE ERP Estimates
Appendix 8B: Other Sources of ERP Estimates
Chapter 9: Build-up Method
1. Introduction
2. Formula for Estimating the Cost of Equity Capital by the Build-Up Method
3. Risk-Free Rate
4. Equity Risk Premium
5. Size Premium
6. Company-Specific Risk Premium
7. Example of the Build-Up Method Using Morningstar Data
8. Example of the Build-Up Method Using Duff & Phelps Size Study Data
9. Summary
Chapter 10: Capital Asset Pricing Model
1. Introduction
2. Concept of Market or Systematic Risk
3. Background of the Capital Asset Pricing Model
4. Market (or Systematic) and Unique (or Unsystematic) Risks
5. Using Beta to Estimate Expected Rate of Return
6. Modifying CAPM
7. Modified CAPM Cost of Capital Formula
8. Examples of a CAPM Model
9. Assumptions Underlying the Capital Asset Pricing Model
10. Summary
Chapter 11: Beta: Differing Definitions and Estimates
1. Introduction
2. Estimation of Equity Beta
3. Differences in Estimation of Equity Betas
4. Modified Betas: Adjusted, Smoothed, and Lagged
5. “Full-Information” Equity Beta
6. Peer Group Equity Beta
7. Fundamental Equity Beta
8. Equity Beta Estimation Research
9. Estimation of Debt Betas
10. Other Beta Considerations
11. Summary
Appendix 11A: Examples of Computing OLS Beta, Sum Beta, and Full-information Beta Estimates
1. Introduction
2. Computing OLS and Sum Beta Estimates Example
3. Computing Full-Information Beta Estimate Example
Appendix 11B: Estimating Beta: Interpreting Regression Statistics
1. Introduction
2. Evaluating Beta Estimation Output
3. Evaluating Regression Output
Chapter 12: Unlevering and Levering Equity Betas
1. Introduction
2. Formulas for Unlevering and Levering Equity Betas
3. Choosing Among Unlevering and Levering Formulas
4. Adjusting Asset Beta Estimates for Differences in Operating Leverage
5. Adjusting Asset Beta Estimates for Excess Cash and Investments
6. Unlevering Equity Volatility
7. Summary
Chapter 13: Criticism of CAPM and Beta versus Other Risk Measures
1. Introduction
2. Capm Assumptions and Beta as a Risk Measure
3. Problems with Capm Assumptions
4. Testing Asset Pricing Models
5. Risk Measures Beyond Beta
6. Summary
Appendix 13A: Example of Computing Downside Beta Estimates
1. Introduction
2. Computing Downside Beta Estimates
Chapter 14: Size Effect
1. Introduction
2. Size as a Predictor of Equity Returns
3. The Size Effect: Empirical Evidence from Morningstar and Duff & Phelps Studies
4. Morningstar Studies
5. Duff & Phelps Studies
6. Estimating Size Premia for a Nonpublic Company
7. Summary
Chapter 15: Criticisms of the Size Effect
1. Introduction
2. Is the Size Effect the Result of Incorrectly Measuring Betas?
3. Composition of the Smallest Sbbi Valuation Yearbook Decile
4. Composition of the Smallest Risk Premium Report Portfolio
5. Data Issues
6. Risks of Small Companies
7. The Size Effect with Boom Years Omitted
8. Is the Size Effect Limited to Only the Smallest Companies?
9. Has the Size Effect Disappeared in More Recent Periods?
10. Should the Cost of Equity Capital Use a Changing Size Premium?
11. Relationship of Size and Measures of Risk
12. Relationship of Size and Liquidity
13. Summary
Appendix 15A: Other Data Issues Regarding the Size Effect
1. Seasonality
2. Bid/Ask Bounce Bias
3. Delisting Bias
4. Transaction Costs
Chapter 16: Company-specific Risk
1. Introduction
2. Matching Risk and Return
3. Risk Differences Often Cannot be Adjusted for in Net Cash Flows
4. Matching Fundamental Risk and Return
5. Market Pricing of Other Company-Specific Risk Factors
6. Cost to Cure
7. Other Company-Specific Factors
8. Bias In Projections
9. Frameworks for Analyzing Company-Specific Risk
10. Summary
Chapter 17: Distressed Businesses
1. Introduction
2. What Is Distress?
3. Valuing Firms in Distress
4. Bankruptcy Prediction Models
5. Cost of Capital for Distressed Firms
6. Valuing Companies Emerging from Bankruptcy
7. Cost of Distress
8. Summary
9. Additional Reading
Appendix 17A: Cost of Capital and the Valuation of Worthless Stock
1. Introduction
2. Liquidating Value
3. Potential Value
4. Example
5. Possibility That Value of the Business Enterprise Exceeds the Face Value of Debt—Pricing Equity as a Call Option
6. Potential Future Value: Probability That Value of the Business Enterprise Exceeds the Face Value of Debt
7. Additional Considerations
8. Summary
Chapter 18: Other Methods of Estimating the Cost of Equity Capital
1. Introduction
2. Fama-French Three-Factor Model
3. Comparing Models
4. Arbitrage Pricing Theory
5. Market-Derived Capital Pricing Model
6. Yield Spread Model
7. Implied Cost of Equity Capital
8. Using Analyst's Forecasts
9. Sources of Information
10. Summary
11. Additional Reading
Chapter 19: Using the Duff & Phelps Risk Premium Report Data
1. Introduction
2. History of the Risk Premium Report
3. Organization
4. Data Sources and Companies Included
5. Period Analyzed
6. Size Study And Risk Study Portfolios
7. Size Study
8. Risk Study
9. High-Financial-Risk Study
10. “C” Exhibits
11. Summary
Appendix 19A: Examples Using the Duff & Phelps Risk Premium Report Data
1. Using the Risk Premium Report
2. Using the Size Study—Examples
3. Using the “C” Exhibits—Examples
4. Using the High-Financial-Risk Exhibits

Part Three: Estimating the Overall Cost of Capital

Chapter 20: Other Components of a Business's Capital Structure
1. Introduction
2. Debt Capital
3. Preferred Equity Capital
4. Convertible Debt and Convertible Preferred Equity Capital
5. Employee Stock Options
6. Obligations that are Subtracted in a Valuation
7. Summary
8. Notes
9. Additional Reading
Chapter 21: Weighted Average Cost of Capital
1. Introduction
2. Where Does WACC Come From?
3. When to Use WACC
4. Valuing the Levered Business Enterprise
5. After-Tax WACC
6. Debt Capacity and Optimal Capital Structure
7. Computing WACC for a Public Company
8. Computing WACC for a Nonpublic Company
9. Should an Actual or a Hypothetical Capital Structure be Used?
10. Should a Constant or Variable Capital Structure be Used?
11. Fixed Book-Value Leverage Ratio
12. Pre-Interest-Tax-Shield WACC
13. Other Tax Shields
14. Summary
15. Additional Reading
Appendix 21A: Iterative Process Using CAPM to Calculate the Cost of Equity Component of the Weighted Average Cost of Capital
1. Introduction
2. Capital Asset Pricing Model and Beta
3. Solution: The Iterative Process
4. Part 1: Value the Firm with Constant Capital Structure
5. Assumptions Inherent in Weighted Average Cost of Capital
6. Solution: Iterative Process with Changing Capital Structure
7. Part 2: Value the Firm with Changing Capital Structure
8. Summary
9. Additional Reading

Part Four: Estimating the Cost of Capital—Non-Freely Traded Interests

Chapter 22: Handling Discounts for Lack of Marketability and Liquidity for Minority Interests in Operating Businesses
1. Introduction
2. Discrete Percentage Discount for Lack of Marketability
3. Using Options to Estimate the Discount for Lack of Marketability
4. Building the Discount for Lack of Marketability into the Discount Rate
5. Measuring Blockage (Liquidity) Discounts for Public Companies
6. Summary
Chapter 23: Cost of Capital of Family Holding Company Interests
1. Introduction
2. Family Holding Company
3. Relationships Between Time to a Liquidity Event and Value
4. Lack of Control
5. Estimating the Cost of Illiquidity
6. Illiquidity Theory
7. Empirical Studies on Embedded Illiquidity
8. Summary
Chapter 24: The Private Company Discount for Operating Businesses
1. Introduction
2. Relationship between DLOM for Minority Interests and PCD
3. Quantifying the Private Company Discount
4. Reasons for the Private Company Discount
5. Summary
Chapter 25: Cost of Capital of Interests in Pass-through Entities
1. Introduction
2. Characteristics of PTEs
3. Gross Decision
4. Delaware Court Adjusts for Tax Differences
5. Family Law Court Adjusts for Tax Differences
6. Market Evidence of Value of Interests in PTEs
7. Cost of Capital for PTEs
8. Risks of Investments in PTEs
9. Summary
10. Additional Reading
Chapter 26: Relationship between Risk and Returns in Venture Capital and Private Equity Investments
1. Introduction
2. Returns on Venture and Private Equity Funds
3. Venture Capital Investments
4. Private Equity Investments
5. Summary
6. Additional Reading
Chapter 27: Cost of Capital for Closely Held Businesses
1. Introduction
2. The Capital Markets
3. Cost of Capital Surveys
4. Using Private Capital Markets Data
5. Total Beta
6. Summary

Part Five: Corporate Finance Officers: Using Cost of Capital Data

Chapter 28: Capital Budgeting and Feasibility Studies
1. Introduction
2. Invest for Returns above Cost of Capital
3. DCF Is Best Corporate Decision Model
4. Focus on Net Cash Flow
5. Capital Cash Flow and Adjusted Present Value Methods
6. Use Target Capital Structure Over Life of Project
7. Summary
8. Additional Reading
Chapter 29: Cost of Capital for Divisions and Reporting Units
1. Introduction
2. Divisional Cost of Capital
3. Reporting Unit Cost of Capital
4. Goodwill Impairment—Cost of Capital Under IFRS
5. Summary
6. Additional Reading
Chapter 30: Cost of Capital for Fair Value Reporting of Intangible Assets
1. Introduction
2. Financial Reporting Context
3. Fair Value Balance Sheet
4. Intangible Asset Income Approach
5. Differentiating Risks among Assets
6. Implied Rate of Return—Unidentifiable Intangible Assets
7. Liabilities
8. Summary
9. Additional Reading
Chapter 31: Cost of Capital in Evaluating Mergers and Acquisitions
1. Introduction
2. Mixed Results From M&A Transactions
3. Invest for Returns in Excess of the Cost of Capital
4. DCF Is the Best Corporate Decision Model
5. Focus on Cash Flows
6. Categories of Cash Flows
7. Estimating the Cost of Capital
8. Value and Price Differ
9. Impact of Recent Market Conditions
10. Contingent Consideration
11. Common Mistakes
12. Summary
Chapter 32: Cost of Capital in Transfer Pricing
1. Introduction
2. Tax Transfer Pricing
3. Cost of Capital Estimates in Transfer Pricing
4. Cost of Capital Estimate
5. Relating Valuation of Acquired Intangible Assets for Transfer Pricing to Financial Reporting (ASC 805)
6. The Role of Capital in Transfer Pricing for Financial Services Firms: Special Focus on Global Dealing Operations
7. Conclusion
Appendix 32A: Cost of Capital in Transfer Pricing Example
Chapter 33: The Role of the Cost of Capital in EVA and in Corporate Value-Based Management
1. Introduction
2. How to Score the Business Game
3. Practical Innovations are Helping
4. Best-Practice EVA

Part Six: Other Cost of Capital Considerations

Chapter 34: Estimating Economic Income
1. Introduction
2. Alternative Net Cash Flow Formulas
3. Financial Analysis of Historical Operating Results
4. Revenue and Profitability Estimates
5. Noncash Charges and Investments in Fixed Assets
6. Investments in Net Working Capital
7. Reasonableness of Estimated Profit Margins and Asset Turnovers
8. Testing Net Cash Flow Estimates
9. Estimating Alternative Net Cash Flows
10. Terminal Value Model Considerations
11. Summary
12. Additional Reading
Chapter 35: Minority versus Control Implications of Cost of Capital Data
1. Introduction
2. Minority versus Control Has Little or No Impact on Cost of Capital
3. Company Efficiency versus Owner Exploitation
4. Impact of the Standard of Value
5. Under What Circumstances Should a Control Premium Be Applied?
6. A Tale of Two Markets
7. Many Takeovers at Less Than Public Trading Price
8. Summary
Chapter 36: How Cost of Capital Relates to the Excess Earnings Method of Valuation
1. Introduction
2. Basic “Excess Earnings” Valuation Method
3. Cost of Capital Reasonableness Check
4. Vagaries of the Excess Earnings Method
5. Summary
Chapter 37: Adjusting the Discount Rate to Alternative Economic Income Measures
1. Introduction
2. Converting from Capitalizing Net Cash Flow to Capitalizing Another Economic Income Measure
3. Converting After-Tax Rates with Zero or Constant Growth
4. Converting After-Tax Rates with Changing Growth
5. Summary
6. Additional Reading

Part Seven: Considerations in Special Applications

Chapter 38: How Courts View Cost of Capital
1. Appraisal and Fairness Cases
2. Estate and Gift Tax Matters
3. Damages for Lost Profits
4. Cost of Capital in Intellectual Property Disputes
5. Bankruptcy
6. Family Law
7. Corporate Restructuring and Other Federal Tax Matters
8. AD Valorem Taxes
9. Regulated Industries
Chapter 39: Global Cost of Capital Models
1. Introduction
2. Risks
3. Cost of Equity Capital Models
4. Modified Models
5. Should Projected Net Cash Flows and the Cost of Capital Be Nominal or Real?
6. Capital Structure
7. Summary
8. Additional Reading
Chapter 40: Cost of Capital of Real Property—Individual Assets
1. Introduction
2. Typical Structure of a Real Estate Transaction
3. Real Property Competes with Other Asset Classes
4. Direct Capitalization Method
5. Discounted Cash Flow Method
6. Estimating the Property Discount Rate
7. Summary
Appendix 40A: Valuing Real Property
1. Introduction
2. Steps in Estimating Real Property Value
3. Determining the Projection (Capital Recovery or Holding) Period
4. Projecting Cash Flows
5. Summary
Chapter 41: Cost of Capital of Real Estate Entities
1. Introduction
2. Definition of a Real Estate Entity
3. Measuring Net Cash Flow for Real Estate Entities
4. Valuation of Real Estate Entities
5. Estimating the Cost of Capital
6. Summary
7. Additional Reading
Appendix 41A: Valuing Real Estate Entities
1. Introduction
2. Measuring Net Cash Flow for Real Estate Entities
3. Projected Cash Flow from Real Estate Operations
4. Projected Net Cash Flow for Real Estate Entity
5. Funds from Operations and Adjusted Funds from Operations

Part Eight: Case Studies

Chapter 42: Cost of Capital for a Mid-Sized Company
1. Case Background
2. Valuation Procedures
3. Cost of Capital
4. Contingent Liabilities
5. Conclusion
Appendix 42A: Report for Cost of Capital for a Mid-Sized Company
1. Section C—Liabilities of ABC OpCo and RE HoldCo
2. Section E—Cost of Capital of ABC OpCo
3. Section H—Leased-Fee Interest Valuation of RE HoldCo Buildings
Chapter 43: Cost of Capital for a Smaller-Sized Company
1. Case Background
2. Valuation Procedures
3. Cost of Equity Capital
4. Conclusion
Appendix 43A: Report for Cost of Capital for a Smaller-Sized Company
1. Section D—Income Approach

Part Nine: Advice to Practitioners

Chapter 44: Common Errors in Estimation and Use of Cost of Capital
1. Introduction
2. Confusing Discount Rates with Capitalization Rates
3. Substituting Ebitda for Net Cash Flow
4. Using Both the Discounting and Capitalizing Methods and Weighting Them
5. Using the Firm's Cost of Capital to Evaluate a More or Less Risky Acquisition or Project
6. Mistaking Historical Rates of Return for Expected Rates of Return
7. Blindly Accepting Morningstar's Long-Term Average as Today's Equity Risk Premium
8. Using an Inconsistent Equity Risk Premium Estimate to That Used in the Industry Risk Premium
9. Using an Inappropriate Beta in the CAPM
10. Using an Inappropriate Beta in a Multifactor Model
11. Using a Safe Rate to Discount or Capitalize a Risky Return
12. Mismatching the Discount Rate with the Economic Income Measure
13. Discounting the Terminal Value for N + 1 Periods
14. Subtracting a Short-Term Growth Rate from the Discount Rate to Get a Capitalization Rate
15. Performing an Excess Earnings Method Valuation That Results in an Unrealistic Cost of Capital
16. Internally Inconsistent Capital Structure Projection
17. Assumptions That Produce a Standard of Value Other Than That Specified in the Valuation Engagement
18. Using the Same WACC to Value Different Businesses Owned By a Diversified Company
19. Incorrect or Inadequately Supported Data in Estimating the Cost of Equity
20. Projecting Growth Beyond That Which the Capital Being Valued Will Support
21. Using an Unattainable Growth Rate in Calculating the Terminal Value
22. Other Errors in Estimating Net Cash Flows
23. Summary
Chapter 45: Advice on Dealing with Cost of Capital Issues
1. Introduction
2. Practical Issues and Advice
3. Summary

About the Website

Appendix I Bibliography

Appendix II Data Resources

Appendix III Glossary of Cost of Capital Terms

Index of Cases

Index

End User License Agreement

List of Illustrations

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ISBN 978-1-118-55580-4 (Hardcover)

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Dedication

To our families for their support and encouragement, without which our careers and this book would not have been possible.

Millie
Son Mike Pratt	Daughter Susie Wilder
Daughter-in-law Barbara Brooks	Son-in-law Tim Wilder
Randall and Kenny	John, Calvin, and Meg
Portland, OR	Springfield, VA
Son Steve Pratt	Daughter Georgia Senor
Daughter-in-law Jenny Pratt	Son-in-law Tom Senor
Addy and Zeph	Elisa, Katie, and Graham
Portland, OR	Fayetteville, AR
Mary Ann
Son Roger Grabowski Jr., MA Daughter-in-law Misako Takahashi Rob, Sayaka, and Asami Tokyo, Japan	Daughter Sarah Harte, MA Son-in-law Michael Harte, MS, JD Kevin and Rosemary Arlington Heights, IL
Daughter Julia Grabowski, MD	Son Paul Grabowski, MS PhD
San Diego, CA	Daughter-in-law Melissa Ruiz, MD Casey and Louis Chicago, IL

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