Estimating Cost of Capital in Today's Economic Environment

INTRODUCTIONA company's success depends heavily on the types of investments it makes in long-term assets used for producing goods and services. Long-term assets are an important part of a company's total assets because they generate cash flows which are necessary for survival and growth and expansion. Therefore, financial managers spend a great deal of time and efforts in making capital budgeting decisions. These decisions entail planning for investments in long-term assets and selecting projects that will increase a company's value and maximize shareholders' wealth in long-term.The analysis begins with an estimation of cash flows which can be classified into initial, interim, and terminal cash flows. Initial cash flows include investment in a project, additional investments in working capital, and any after- tax cash flows from sale of an old asset. Interim cash flows include net increase in revenues as a result of investment in a project. Terminal cash flows include net cash flows from sale or disposal of an asset and any recovery of working capital. At the conclusion of a project, the asset might be sold and provide cash flows. Also, working capital might be reduced to its original level and provide additional cash flows.The cash flows estimation is followed by evaluation of cash flows which includes using different evaluation measures such as Net Present Value (NPV), Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR), Profitability Index (PI), Regular and Discounted Payback Period, etc. These measures, with an exception of Regular Payback Period, discount future cash flows to their present values to evaluate whether a project will provide sufficient cash flows and increase the value of a company. The cash flows are discounted using a discount rate corresponding to the riskiness of a project which is the company's Weighted Average Cost of Capital (WACC) adjusted for the level of riskiness of a project. For example, a company might classify projects into above average, average, or below average risk levels. The company's cost of capital (let us say 8%) might be used to discount cash flows from average risk projects. And the discount rates for projects with above or below average risk might be adjusted (let us say 2%) to account for the riskiness of projects. In our example, the discount rate for below average risk projects will be 6% (8%-2%) and cash flows from above average risk projects will be discounted by 10% (8%+2%).A company's cost of capital plays and important role in making capital budgeting decisions. Cost of capital is also instrumental in making other business decisions such as compensation to managers, capital structure (appropriate level of debt and equity), lease or buy, etc. Cost of capital is also used in regulating utilities such as water, electric, gas, etc. who enjoy monopolistic powers in markets. For these organizations, cost of capital can be used to determine the appropriate price (rates) they can charge to their customers.However, recent surveys by Association for Financial Professionals (AFP) have found a lack of consistency in computing cost of capital. In October 2013, AFP published its report of survey of more than 400 financial professionals representing a wide variety of organizations. In the following sections, I review different measures and approaches used by managers to compute cost of capital and apply one of the approaches to a hypothetical company, ABC Company, to demonstrate the impact on the cost of capital. Projects are analyzed using different discounting factors (cost of capital) to study the viability of projects based upon different discounting factors. Finally, the appropriate measures and approaches to compute cost of capital accurately are discussed.ABC Company: Following are the Long-Term Liabilities and Equity of the company:Other information: Number of Outstanding Bonds: 2 MillionPrice Per Bond: $875Number of Outstanding Common Shares: 50 MillionPrice Per Share of Common Stock: $91Number of Outstanding Preferred Stock: 200 MillionPrice Per Share of Preferred Stock: $3. …