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.

• E-mail
• Print
• Link

(2) Noninterest-bearing liabilities such as accounts payable and taxes payable are not included in this calculation because a firm's financial management does not typically control them. These "spontaneous" liabilities are due to sales and spending activity, and they directly affect a firm's operating cash flows rather than its WACC. From a DCF valuation perspective, these noninterest-bearing liabilities are treated as a factor influencing the firm's cash flows rather than the discount rate or WACC that is used to discount these cash flows.

(3) By this definition, the WACC estimate should be forward-looking rather than based on past historical data. As we shall note later in this article, however, often the only practical way to form a forward-looking WACC estimate is by using past data and historical relationships.

(4) Note that target weights rather than those based on existing market or book values are justified by the assumption that the firm's capital structure will, over time, gravitate toward these target values and, therefore, can be considered more appropriate than market or book values reported at one point in time. Yet in Robert F. Bruner, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins, "Best Practices in Estimating the Cost of Capital: Survey and Synthesis," Financial Practice and Education, Spring/Summer 1998, pp. 13-28, we find that the vast majority of large firms used market values rather than book or target values when estimating the relative weights of debt, equity, and preferred stock.

(5) If the firm also has preferred stock in its capital structure, Equation 2 is amended to include the product of the weight of preferred stock in its capital structure, [w.sub.ps], and the expected return on the preferred stock, [K.sub.ps]. Typically, the market value of preferred stock is used to estimate [w.sub.ps], or a target percentage can be used, and the current dividend yield is used as an estimate of the expected return on the preferred stock, that is, [K.sub.ps] = [Dividend.sub.ps]/Market [Price.sub.ps].

(6) S. David Young and Stephen F. O'Byrne, EVA[R] and Value-Based Management: A Practical Guide to Implementation, McGraw-Hill, New York, N.Y., 2001, pp. 161-203; and Bruner, Eades, Harris, and Higgins, 1998, describe the assumptions underlying these two models and how to estimate [K.sub.s] using both approaches. The interested reader can consult these books for a detailed treatment of these two methods of estimating [K.sub.s].

(7) Marshall Blume, "Betas and Their Regression Tendencies," Journal of Finance, June 1975, pp. 785-795. Blume's key insight is that a firm's beta measured over one time period tends to revert toward a mean close to 1.0 when measured over a subsequent time period. Thus, empirically estimated betas tend to revert over time to a mean of approximately 1.0. Blume's 1975 article shows in detail how to adjust for this "mean-reversion" bias in estimated betas.

(8) See Young and O'Byrne, 2001, pp. 161-203, and Bruner, Eades, Harris, and Higgins, 1998, pp. 13-28. The issues related to estimating these other components are discussed later when we present our empirical results for GE and Microsoft.