The cost of capital, or discount rate, is one of the most important variables used in the valuation of an asset or entity. A cost of capital attempts to determine the rate of return an investor requires for a certain investment.
While the development of the cost of capital may seem like a simple task, there are numerous mistakes people make in its calculation. And, unfortunately, small changes in the cost of capital can have large effects on the value of an asset or business.
For example, value is generally determined by some variant of the formula: expected cash flow / capitalization rate. If an investment was projected to earn $100 and the capitalization rate was 10%, the value of that investment would be $1,000 (i.e., $100/10%). If the capitalization rate was just two percentage points lower, the value of the investment would be $1,250 (i.e., $100/8%), an increase in value of 25%.
Below is a brief summary of a few of the more common mistakes made in the development of a cost of capital:
- Discount rate vs. Capitalization rate – While a capitalization rate is simply the discount rate less long-term expected growth, it is easy to accidentally use the two rates interchangeably. However, a discount rate is normally used to calculate the present value of future cash flows over a period where growth in the future cash flows is expected to vary. Once cash flows are expected to grow at a constant rate, a capitalization rate can be used to estimate the present value of all future cash flows in perpetuity.
- Subtracting short-term growth, which may be overstated – When using a capitalization rate, many people often look at the recent historical growth or expected growth over the next few years and use either of those as a proxy for the long-term growth rate. However, especially in growing companies, these growth rates are often high and likely overstate long-term, sustainable growth. In many cases, it may be necessary to forecast cash flow for a few years until growth rates have stabilized, and then use a capitalization of earnings. A related error is not considering the riskiness of the forecast being used in a valuation. For example, if a company prepares three forecasts: a worst-case, conservative, and best-case forecast, it does not mean that there should be three separate values for the business. Rather, an analyst must consider the riskiness of each forecast and adjust the discount rate to account for this risk.
- Applying Costs of Capital Derived from After-Tax Data to Pre-Tax Cash Flow – The data used to develop a cost of capital is generally derived from after-tax data and therefore should only be applied to after-tax cash flows. While this issue gets more complex when considering an S Corporation versus a C Corporation and is beyond the scope of this article, the general idea still applies.
- Cost of Equity vs. Weighted Average Cost of Capital (“WACC”) – A cost of capital can refer to both a cost of equity and a WACC. However, the cost of equity and WACC are very different and each should only be applied to certain types of cash flow. The WACC should be applied to cash flow to invested capital (i.e., cash flow available to equity and debt holders) and the cost of equity should only be applied to cash flow to equity (i.e., cash flow available to equity holders, after debt holders have been paid). This is a very common mistake, which can have a significant impact on value.
As can be seen, there are numerous potential pitfalls that one can encounter when developing a cost of capital. However, with careful and thoughtful analysis, a reasonable and supportable cost of capital can be developed. If you require assistance in calculating a cost of capital or valuing a business, please contact Steve Thimons at 412-697-5281.
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