“Each year in the US, corporations undertake more than $500 billion in capital spending” (Bruner 184). This case presents a reasonably analyzed set of teaching notes describing how these financially sophisticated corporations estimate their capital costs. Understanding the estimation of capital costs helps identify the uncertainty of the cost-of-capital theory, sets a benchmark for cost-of-capital, helps determine the accuracy of estimating costs, and solves the problem of how a company really estimates their cost of capital.
When dealing with the estimation of capital costs, companies are left to their own discretion on …show more content…
The last and most controversial variable of determining the cost of equity is the market risk premium (Rm – Rf). The main discrepancies arise when computing the average historical equity returns (arithmetic or geometric). To further inquire, when arithmetically computing the equity returns, an average of past returns is used with the assumption that all returns are stable, evenly distributed, and independent through each period. On the other hand, when geometrically computing the equity returns, an internal rate of return is calculated between a single outlay and future receipts. This compound rate is used to portray an investor’s return over past periods.
With that being said, an arithmetic approach tends to work best for computing the expected returns, while the geometric approach works best for outlaying a historical investment experience. Additionally, neither method is necessarily better than the other, but the arithmetic mean return over T-bills tends to be used more often than the geometric mean. However, both approaches are still focusing on past returns, while the CAPM method calls for forward-looking variables. The differences arise when defining a forward-looking variable that reflects the current market risk premium. Risk Adjustments to WACC Risk is another important factor of the WACC. Only when a company’s WACC can be used as a benchmark for a firm’s average risk investments should a single WACC be used.