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Before starting to describe the problems associated to the estimation of the cost of capital, it is extremely relevant to describe its meaning: according to Investopedia, it is “the cost of funds used for financing a business”. In order to carry out this process, the companies can only be financed through equity; only through debt; or using a “combination of debt and equity” – in this particular case it is a “overall cost of capital derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC) (…)” (Investopedia, 2013).
The estimation of the cost of capital depends on several factors, such as the “operating history, profitability, credit worthiness, etc.”. It means, of course, the most recent companies will face higher costs of capital because their risk is higher when compared to solid companies (Investopedia, 2013).
It is now important to describe a few and the most important problems regarding the estimation of the cost of capital:
” (Jacobs and Shivdasani , 2012). It will make the managers decide whether they invest or not in a project and also if a company will be successful financially. Thus, if the company has made an underestimation to its capital cost, it will may see “a flashing green light” in terms of the Net Present Value; on the other hand, if there is an overassumption regarding the capital cost, the project might “be cast aside”, as it will show a loss or a lower Net Present Value than the real one (Jacobs and Shivdasani, 2012).
In a more precise way, there are two main problems regarding the assumptions done: – The first one is about estimating the cost of equity in which two different methods can be used (CAPM Model and Dividend Discount Model). The problem is that in each of those models, at least one of the variables is an estimation. Due to this variations, the cost of capital will also vary; Concerning the estimation of the cost of debt, there is a risk-free rate and a risk premium. There is a problem with both, but the risk-free rate’s problems will be explained at a further stage. In terms of the risk premium, it depends on the debt and it should be higher as the amount of debt raises (Finance Train, 2013).
Another point regarding the estimation of Beta has to do with two of the problems already described, regarding the Treasury Yields and the Equity Risk Premium. If there is, for instance, a decline in financial stocks and companies with a high level of average exceed the “outpaced market”, it brings a misleading Beta; that means the risk has actually declined. Thus, the market is overweighted with financial stocks that pulled the index down through their declining and if you compare the non-financial companies’ stock covariance to the pre-crash and its post-crash covariance, it will witness a lower beta because it will seem the risk has decreased (Grabowski, 2009).
The third point in what concerns to the Beta Estimation has to do with the leverage and its impact on that coefficient estimation. A company should adapt its capital structure over time, that is, the cost of capital should reflect likely changes according to the company’s capital structure. For instance, a company with a high level of leverage might not be able to sustain its debt loads forever which will have impact on the estimation of Beta. In this particular case, one should “un-lever” the Beta estimate to reduce or remove “the effect of financial risk from the beta estimates (Grabowski, 2009, p. 15)).
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