Cost of Capital Inputs Vary

U.S. businesses are sitting on a heap of cash, and as economic activity flows more freely, they're expected to start spending that money. But the measures that companies use to assess possible transactions vary widely, according to a recent survey by the Association for Financial Professionals (AFP).

Discounted future cash flow, a standard measure for valuing possible acquisitions or divestitures, was employed by 79% of the more than 300 companies AFP surveyed, and by 91% of the companies that had more than $1 billion in revenue. But the survey shows that when companies calculate their weighted average cost of capital (WACC), the number used to discount the future cash flows, there are big differences in the numbers they use for such inputs as the risk-free rate, beta factor and the market-risk premium.

For example, says Brian Kalish, director and finance practice lead at AFP, "there's very little agreement on what the risk-free rate is."

According to the AFP survey, 46% of companies use the 10-year U.S. Treasury note as the risk-free rate, while 16% use the three-month Treasury bill, 12% a five-year Treasury note, 11% the 30-year Treasury bond and 5% the one-year Treasury bill.

"In these times, when you have quite a steep curve, you're talking about almost a four-point difference between the three-month bill and 30-year bond," Kalish notes.

The differences don't end there. While almost half the companies use the current rate of their chosen security as the risk-free rate, 35% average the rate over some period of time and 14% use forward curves to forecast the rate on the security.

Companies also vary in the sources they use for other parts of the calculation. Fifty-nine percent get their beta factor from Bloomberg, while 10% use Ibbotson, 6% Barra and 5% Value Line. Almost half (49%) of the companies use a market risk premium that's between 5% and 6%, but 11% use a number under 3%, 23% use a number between 3% and 4%, and 17% cite a market risk premium of 7% of more.

Kalish says that given the differences in the inputs organizations use to calculate their cost of capital, two companies in otherwise similar situations could end up making very different decisions.

"I think what happens is that, especially in [financial planning and analysis], you kind of live in your own little world," he adds. "The way you do things and your companies do thing is what you think is normal. Then when you start lining people up side by side, you see there's quite a lot of difference."

AFP intends to continue working on this topic in hopes of eventually developing some best practices or benchmarks, Kalish says. "There's got to be 40%, 50%, 60% that can be standardized."

A summary of the AFP survey can be found here.