How Do Companies Calculate Their Cost of Capital?

A new AFP survey finds only 8 percent of companies think their WACC estimates accurately reflect their actual cost of capital. Here's where those companies are getting their WACC figures.

On Monday, the Association for Financial Professionals issued its “2013 AFP Estimating and Applying Cost of Capital Survey Report.” The survey of 424 finance professionals found that although financial planning and analysis (FP&A) might be the department that makes the most use of weighted average cost of capital (WACC) figures, it is generally not the department responsible for coming up with WACC estimates. In 46 percent of respondents’ companies, treasury is responsible for WACC calculations. This responsibility falls to finance in 32 percent of companies and to FP&A in only 18 percent.

More than half of respondents think their organization’s WACC estimate is within 50 basis points (bps) of its actual cost of capital, but 11 percent believe the WACC is off by more than 100 bps. Large companies are three times as likely to think their WACC calculations are more than 1 percentage point away from actual cost of capital (see Figure 1).

The survey also explored how companies estimate their cost of equity. Eighty-five percent of respondents use the Capital Asset Pricing Model (CAPM); only 4 percent use the Dividend Discount Model (DDM), and 2 percent use the Arbitrage Pricing Model (APM).

Among those that use the CAPM, the most popular instrument used in estimating risk-free rates is the 10-year Treasury (39 percent), followed by 90-day Treasuries (17 percent), 5-year Treasuries (14 percent), and 52-week Treasuries (12 percent). An increasing number of companies are imposing a floor, a cap, or both on the risk-free rate they use in evaluating projects and investments (see Figure 3). Among these, the average floor for the risk-free interest rate is 4 percent. The average rate cap is 8 percent, although the average among companies with less than $1 billion in annual revenue is 10 percent and the average among larger companies is 7 percent.

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