Calculating a firm's cost of capital: three different methods of determining the weighted average cost of capital for Microsoft and general electric produce different results for each firm. Thus, careful judgment and sensitivity analysis are important components for developing reliable cost of capital estimates

Management Accounting Quarterly,  Spring, 2004  by Michael S. Pagano,  David E. Stout

Tags: financial, Microsoft Corp.

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The last three rows of Table 2 present the three sets of WACC estimates based on the adjusted-beta CAPM, APM, and BY+P methods. Given the variability in the cost-of-equity estimates in Table 1, it is not surprising that the three methods for calculating WACC also yield substantial differences. For example, GE's WACC ranges from 6.06% (using the adjusted-beta CAPM) to 8.55% (based on the APM). Microsoft's estimates are less dispersed than GE's but also display a sizable range of 1.5 percentage points (from a low of 8.32% to a high of 9.83%). In general, deviations similar to the magnitude reported in Table 2 (if not greater) are commonly found when applying the theory of cost-of-capital estimation to real-world companies.

VARIABILITY IN WACC ESTIMATES

With such large variations in estimates of companies' WACC, an analyst must exercise judgment when selecting a final estimate of the firm's weighted average cost of capital. For example, the analyst might consider creating a simple average of the various WACC estimates. In theory, this averaging process could produce a more accurate final WACC estimate because errors in one estimation method might be canceled by errors attributable to another method. (22)

Alternatively, the analyst might consider performing sensitivity analyses by using each of the different WACC estimates within the particular decision model--such as the DCF capital budgeting model. The analyst might find that the net present value (NPV) calculation in the model is not affected greatly by the choice of either the high, low, or average WACC estimates. In this case, he or she can feel more confident about the capital budgeting decision and valuation estimate.

A serious dilemma arises, however, when different WACC estimates yield materially different "signals" from the valuation model. In this case, disclosure of the valuation model's sensitivity to the choice of WACC might be appropriate. For example, when the valuation model's estimates are highly sensitive to the choice of WACC, the analyst could report the minimum and maximum valuation estimates in order to provide some indication of the magnitude of this sensitivity.

GRAPPLING WITH IMPRECISE ESTIMATES

Finance and accounting professionals need to be able to estimate the weighted average cost of capital because it pervades their work. They need WACC estimates for implementing the asset-impairment requirements of Statement of Financial Accounting Standards (SFAS) No. 144, "Accounting for the Impairment of Long-Lived Assets," for example. They also need WACC for capital budgeting and equity valuation analyses, and for computing financial performance metrics such as EVA[R] and residual income.

A way forward, therefore, is for corporate accounting and finance professionals to use several methods for estimating WACC and choose a simple average of the estimates. Also, because of the inherent subjectivity involved in the WACC estimation process, we recommend they use sensitivity analysis whenever such estimates are used in managerial decision models.