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Journal of Corporate Real Estate Volume 1 Number 3

Estimating the cost of capital

Charles Ward
Received (in revised form): 15th February, 1999
University of Reading, Department of Land Management and Development, Whiteknights,
PO Box 219, Reading, Berks RG6 6AW; Tel: 0118 987 5123; e-mail:

Charles Ward is MA of Cambridge and already undertaking; and how it can be used
Exeter, PhD from Reading and a Fellow of the to consider projects that lie outside the normal
Institute of Investment Management and range of business activities of the firm.
Research. He has taught in several univer-
sities: he was Professor of Accountancy and Keywords: cost of capital, capital
Finance at the University of Stirling and budgeting, investment appraisal
Deputy-Principal from 1989 to 1991, before
moving to the University of Reading. His
wide-ranging teaching and research include INTRODUCTION
investment performance, financial reporting, One of the most important financial deci-
accounting and finance, as well as the sions, and one that most senior managers
behaviour and performance of the property come across at some time in their careers,
market. He published the first CAPM-based is to assess whether the firm should invest
study of UK unit trust performance (1976), the a large amount of money in an investment
first application of option pricing to property project. This decision may affect cor-
(1982) and the first analysis of the smoothing porate real estate managers either directly
effect in appraisal-based indices (1987). His or indirectly. For example, there may be
recent work has mainly been concerned with a proposal to take over or merge with
investment performance and pricing issues. another company; this may involve the
The second edition of his book on ‘British valuation of the properties owned by the
Financial Institutions and Markets’ (co-authors target company and a decision on main-
Piesse and Peasnell) was published in 1995 taining or closing specific plants. Alterna-
by Prentice Hall. tively the company may wish to build or
rent a new factory. Such decisions will
often be accompanied by complicated
ABSTRACT financial analyses setting out the justifica-
This paper introduces the ways of estimating tion of the proposal.
the cost of capital. It briefly reviews the main Although many different methods are
theories of capital structure before explaining commonly used to assess the value of new
how the use of fixed-interest debt finance might projects or investments, the most rigorous
affect the cost of capital. It then considers ways and consistent involve forecasting future
of estimating the cost of equity and finally cash flows and discounting the forecasts at
brings results together. Two final issues are an appropriate rate of interest to arrive at
Journal of Corporate Real Estate
considered: how the cost of capital can be used a present value. Usually the answer is Vol. 1 No. 3, 1999, pp. 287–293.
䉷Henry Stewart Publications,
to appraise projects like the ones the firm is presented as a percentage rate of return.1 1463–001X

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Estimating the cost of capital

The implication is that the rate of return market valuation available to the owners
from the project should be higher than of the firm and so it is more difficult to
the firm’s cost of capital if the project is to measure the success or failure of manage-
be accepted. However, although this may ment decisions. Therefore for non-listed
be familiar, many managers have only the companies, it may be a specific objective
vaguest idea of how the appropriate dis- to try to estimate what is their cost of
count rate is chosen. Furthermore, it capital, ie the cost that they would have
appears that even when the firm calculates to pay if they were listed in the stock
the cost of capital correctly, it may use a market.
different cost of capital to evaluate new The criterion which managers should
projects! It therefore seems that there may adopt in seeking guidance on whether or
be practical and conceptual difficulties not to invest in a project or property is:
facing managers when asked to evaluate ‘Will this increase or decrease the share
capital budgeting decisions. price?’ The practical consequence is that
This paper is the first of two on the managers should forecast the expected
subject of the cost of capital. It will set out cash flows from the investment being
the ways in which any large company appraised and value them by discounting
(with shares listed on the stock exchange) at the appropriate cost of capital. If the
can estimate an appropriate cost of capital. net result is positive, the project, once
It will examine the issues that a firm adopted, should increase the share price.
has to face if it wants to implement a If negative, it should reduce the share
comprehensive framework for examining price.
financial decisions. In the second paper,
we will then contrast this with the prac-
tices commonly encountered in business CAPITAL STRUCTURE THEORY
and try to reconcile the apparent gap There is no free lunch in borrowing
between theory and practice. We will money. If the company cost of capital is
find, by using the results of the latest 13 per cent (which may result from the
academic research, that we are able to average of the cost of equity, say 15 per
justify, or at least understand, the proce- cent, and the cost of debt, 7 per cent),
dures adopted by large companies when there are two consequences of borrowing
controlling capital expenditure. additional money from the bank at 7 per
cent. The amount of debt in the com-
pany’s capital structure will increase —
NET PRESENT VALUE reducing the cost of capital — and the
How valuable is our house or our car? risk will increase for the shareholders,
Most people keep an eye on the value of who will therefore expect higher returns,
these assets by checking on the market which will increase the cost of capi-
price reflected in estate agents’ or garages’ tal. The whole issue of capital structure
advertisements. In the same way, we assert depends on the relationship between these
that the best valuation of a company is two effects. We can express this by the
reflected in the market value of the shares formula:
and debt issued by the company. Clearly,
managers cannot control market move- WACC ⫽ KdPd ⫹ KePe (1)
ments, but they can influence the rating
which is given by the stock market. where Kd is cost of debt, Pd the proportion
If a company is not listed, there is no of debt, Ke cost of equity and Pe equals

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the proportion of equity. The implica- uncertainty of maintaining the tax

tions of this formula are that managers shield. Thus there may be an optimum
should (a) use this rate to value business but it may be subject to all sorts of
projects which maintain the business risk of institutional preferences and distor-
the company and (b) only accept projects tions.
which yield a higher return.
To continue the example above, if a Although there are still disagreements be-
firm were financed in the proportion of tween researchers as to the extent of,
25 per cent debt and 75 per cent equity, say, the bankruptcy or the effect of tax,
with returns of 7 per cent and 15 per cent most writers would agree on adjusting the
respectively: average cost of capital by at least the
tax-shield effects of debt. That is, since
WACC ⫽ (0.07 ⫻ 0.25) ⫹ (0.15 ⫻ 0.75) companies can legitimately claim that in-
⫽ 13%. terest payments are an operating cost, the
amount of tax due will be reduced if
However, we have recognised that if more interest is paid. In broad terms, this
we increase the amount of debt, equity is allowed for by modifying the formula
holders will at some stage become nerv- used in equation (1) to include the after-
ous and demand a higher return. One tax cost of debt rather than the before-tax
issue in estimating the cost of capital is, cost. So, if we are paying interest at 7 per
therefore, how to adjust the estimate to cent and the corporate tax is 30 per cent,
allow for different levels of gearing. the after-tax cost of debt would be:

7% ⫻ (1⫺0.3) ⫽ 4.9%
OF CAPITAL The WACC of the previous example will
There is no dispute that as we increase thus be reduced to:
gearing, so equity holders will require
higher returns. The issue is whether this WACC ⫽ (0.049 ⫻ 0.25) ⫹ (0.15 ⫻ 0.75)
increase outweighs the effect of borrow- ⫽ 0.125 or 12.5%.
ing more capital at lower (fixed) rates of
interest from the debt holders. The argu- When we look at the components of the
ment depends therefore on the net effect issued capital of companies, we find a
of gearing on the average cost of capital. wide range of securities (including con-
There are three main views: vertible bonds, preferred stock and float-
ing interest debt) used by companies to
— Traditional:2 As we increase the amount finance their operations. In this paper, for
of gearing, the cost of capital first falls simplicity, we assume only fixed-interest
then rises — there is an optimum. debt and equity. To value these two or to
— Modigliani and Miller or M&M:3 As we assess their required returns, we will ex-
increase the amount of gearing, the amine each in turn.
cost of capital remains the same unless
there is a tax shield effect, in which
case it is reduced by the amount of the Cost of debt
tax shield. We can obtain from services such as
— Modified M&M: There are limits be- Reuters and Datastream various prices and
cause of costs of bankruptcy and the yields for bonds. The simplest approach

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Estimating the cost of capital

for estimating the required return on debt panies. It assumes that efficient investors
is to use the redemption yield. In financial are already diversified. They can there-
terms, this is the internal rate of return fore disregard total uncertainty and con-
that equates the current price of the bond centrate on the effect on their portfolio of
to the cash flows. However, the redemp- company actions.
tion yield can overestimate the return
from the bond if there is any chance of K ⫽ Rf ⫹ ␤ (Expected Market Return
default. It also, as Brealey and Myers ⫺Rf) (3)
(1996) point out,2 assumes that the rates
of interest are constant throughout the life where Expected Market Return ⫺ Rf
of the bond, and it can therefore produce equals Equity Risk premium; Rf is
misleading estimates. However, with this the risk-free rate (Treasury bill rate or
proviso, we can usually get a reasonable Government bond rate); and ␤ is the risk
approximation to the cost of debt by factor of the company.
using the current redemption yield on the The advantage of the CAPM is that
corporate debt. it can be used to adjust for risk consis-
tently. We can even use public sources
to arrive at the parameter ␤ (available
Cost of equity from Datastream, Bloombergs and the
To estimate the required return on equity London Business School Risk Measure-
is rather more problematical. There are ment Service). However, we need to
two main methods used. The first is enter the estimated return from market
by using the dividend discount model and the risk-free rate. We might take the
(DDM) and the second is using the capital risk-free rate as the current Treasury bill
asset pricing model (CAPM). rate, so if that were currently 6.5 per
The DDM values shares by assuming cent, the expected return on the equity
that dividends will grow at a constant market might be assumed to be anything
rate. from 3 to 8 percentage points above 6.5
per cent. It also appears that the central
Ke ⫽ Dividend/Share Price assumption, that shareholders are already
⫹ Expected Growth (2) efficiently diversified, may be too strong
to influence some decisions. For ex-
The advantage of the DDM is that it is ample, one motive which companies
simple to estimate, although we might appear to have in taking over other
each arrive at a different number. The companies is to diversify. But if we used
disadvantage is that we are not sure of the the CAPM to value the change in risk
consistency of the approach. For example, we would recognise that it makes no
the share price reflects the market’s view difference to the efficiently diversified
of the future growth prospects of the investors if they held the shares in two
company, but there is no obvious way of separate companies, or in the one com-
finding out this expected growth and pany formed by merging the two inde-
comparing it with the growth the com- pendent ones. For example, what would
pany itself expects. be the difference between a shareholder
The CAPM has a rather more rigorous holding shares in both Brixton Estates
basis and is widely used in the USA for and Land Securities and holding shares
calculating the required return on the in Land Securities after it had taken over
equity of, for example, regulated com- Brixton Estates?

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PROCEDURES FOR ESTIMATING upon the risk of the assets and projects
AND USING COST OF CAPITAL owned by the company. Accordingly, if we
If we understand these component costs are considering a project that fits outside the
we can specify the procedure to estimate normal activity of our company, we can
the cost of capital in the following form. identify the appropriate cost of capital by
identifying a company that normally invests
Replacement of existing work and in such projects. Suppose, for example, that
involving comparable risk to present a company has been operating in the
activities printing sector with a cost of capital of 12.5
per cent, a debt ratio of 43.5 per cent and
(1) Estimate cost of equity. corporate tax rate of 30 per cent. The cost
(2) Estimate the relative weights of equity of capital of that firm depends on first, the
and debt in company capital structure. business risk of printing and secondly, the
Note that the weights should be the financial risk of the firm. The managers of
market value rather than the book the printing firm may consider taking over
value. a company in the transport business. What
(3) Estimate the average cost of debt. sort of return should they expect to earn?
(4) Estimate the effect of any hybrid Their calculation should follow this proce-
securities such as convertibles, pre- dure:
ference shares and warrants.
(5) Assume an effective marginal tax (1) Identify a company or companies
rate. operating predominantly in the
(6) Use equation (1) to calculate the cost transport sector.
of capital (including the after-tax cost (2) Estimate its or their cost of capital; call
of debt). this WACCref.
(3) Adjust WACCref to reflect the
Note that in this calculation we assume difference in gearing between the
that the company is maintaining the same transport companies and the printing
capital structure as used currently. If this company (WACCx) by the following
assumption is not true, we have to modify expression:4
it by using the adjustment described
below. WACCx ⫽ WACCref [Pex⫺T.Pdx]/
[Pdx⫺T.Pdref] (4)
Appraising new activities of a
different risk profile where T is the applicable corporate tax
Sometimes we can assess the risk of a rate.
project because it amounts to ‘the same as We might find, for example, that the
before but newer’. In other words, the cost of capital of transport firms is 10.2
project is similar to those projects already per cent (WACCref) while the proportion
being undertaken by the company. of debt in their capital structure is 23.3
In other cases, the project may differ per cent. Remembering that the printing
sharply — it may be a new venture, or it company has a debt/total value ratio of
may be closer to another sector or industry. 43.5 per cent, we can then substitute the
Alternatively, it may appear to be highly values in equation (4). Thus:
uncertain and difficult to value at all (eg a
speculative investment in Moscow!). The WACCx ⫽ 10.2% (1⫺0.30 ⫻ 0.435)/
cost of capital of the company will depend (1⫺0.30 ⫻ 0.233) ⫽ 9.6%

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Estimating the cost of capital

In other words, the cost of capital that the project. With hybrid securities, it
we should use to evaluate transport-type may be necessary to estimate different
projects (9.6 per cent) is lower than the costs depending on whether they are
cost of capital that we are earning in the effectively equity or debt. No easy
printing sector (12.5 per cent) and lower answer here.
than the cost of capital that is being — Should we allow for inflation?
earned by firms already in the transport If using market rates of interest, we use
sector (10.2 per cent). The cost of capital nominal cash flows, that is the cash
is lower than in the printing sector be- flows we expect to experience. If we
cause of the lower business risk and lower have to prepare investment appraisals
than other firms in transport because our in real terms, we should convert our
debt ratio is higher (the more debt, the cost of capital into real terms too.
greater the tax shield). — What is the risk-free rate?
Strictly speaking, the risk-free rate is
the return on a security that is certain
ISSUES THAT CANNOT EASILY BE for the period invested. Since most
RESOLVED IN PRACTICE academic research is conducted on
There are several practical complications monthly or quarterly data, it makes
in estimating and using the cost of capital. sense to assume that the risk-free rate
To some of these questions, there is no is the Treasury bill rate since (a) there
widely recognised ‘right’ answer. In other is no chance of default and (b) the
cases, the answer may be clear but users return over the period of one or three
may not apply the theory correctly be- months is exactly defined by the
cause they relax crucial assumptions. buying price. With longer intervals, it
Amongst the most important are the is not so easy. For annual intervals, for
following: example, a short-term Government
bond will usually pay interest half-way
— How often should the WACC be calcu- through the year. The total return by
lated? the end of the year may therefore
In principle, as often as a decision is vary because of possible interest rate
required; in practice, companies rarely changes between now and the time at
change the cost of capital more fre- which the interim interest payment
quently than quarterly and some do so can be re-invested.
only annually.
— Should we use book values or market
We should use market values if pos- AND PRACTICE?
sible. Thus if bonds were originally Although most businesses are familiar
issued at £100 and subsequently inter- with the principles outlined above, it is
est rates have fallen, the bonds will be still widely accepted that capital budgeting
worth more (and the gearing may be decision-making rarely relies only on the
correspondingly higher). NPV analysis. Also, several authors have
— How do we take into account bank loans, found that to value projects, businesses
convertible loans and preference shares? use a hurdle rate of interest which is
Net out all current liabilities and as- significantly higher than the cost of
sets, as the cost of capital is primarily capital. In the next paper, we look at the
reflecting the long-term financing of reasons why this gap exists, and whether

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the different approaches adopted in com- straw man that can easily be knocked
mercial life are justified. down. See, eg, Brealey, R. A. and
Myers, S. C. (1996) ‘Principles of
Corporate Finance’, McGraw-Hill, 5th
REFERENCES international edition, or Ross, S. A.,
(1) A very useful paper on the practical Westerfield, R. W. and Jaffe, J. (1996)
aspects of capital budgeting can be found ‘Corporate Finance’ 4th edition, Irwin,
in R. F. Bruner, K. M. Eades, R. S. McGraw-Hill.
Harris and R. C. Higgins (1998) ‘Best (3) Modigliani, F. and Miller, M. H. (1958)
Practices in Estimating the Cost of ‘The Cost of Capital, Corporation
Capital: Survey and Synthesis’, Financial Finance and the Theory of Investment’,
Practice and Education, Spring/Summer, American Economic Review, Vol. 48, June,
pp. 13–28. pp. 261–297.
(2) Although this traditional view is repeated (4) This is an approximation. See Brealey
in most modern textbooks, it has usually and Myers for the full discussion on this
been presented only in the spirit of a topic.

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