Wednesday, 8 October 2014

You are a lot better estimating the Cost of Capital without using fancy formulas

Estimate the Cost of Capital 
You have to estimate the cost of capital.  

First of all, the cost of equity will always be above the cost of the debt.  Secondly, the most expensive cost of equity is the type that venture capitalists have to pay.  If you read the VC magazines, they will tell you what returns they have to show on their old funds to raise money on their new funds.  These days that number is 15%.  Without doing any betas, you know the cost of equity is between 7% and 15% which is a lot better than the beta estimates.  

  • Usually for the low risk firm with not a lot of debt, the cost of capital will be about 7% to 8%. 
  • For a medium risk firm these days with reasonable debt, it will be about 9% to 10%.  
  • For high risk firms, it will be 11% to 13%.

You are a lot better doing that than trying to estimate using fancy formulas.  So you get a cost of capital.

And the nice thing about not including the growth is that errors in the cost of capital are typically not that big. If you are 1% off in the WACC, you are 10% error in the valuation and that is not a killer error in valuation. 

Notes from video lecture by Prof Bruce Greenwald
Cue:  7/11

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