January 1999 Issue

COST OF CAPITAL: ESTIMATION AND APPLICATIONS

By Shannon Pratt, John Wiley & Sons, Inc., 1998

Reviewed by James F. Morrell, CPA

Do you know how to estimate the cost of capital of an enterprise? The estimation methods and techniques can be somewhat complex and require subjective reasoning as well as objective calculation. Proper estimation is the key, as evidenced by the subtitle of Shannon Pratt's Cost of Capital: Estimation and Applications. The author provides a definitive look at the many and varied aspects of the subject.

To this reviewer, the book sets out one of the most accessible treatises on the subject. Beginning with the definition of the cost of capital, "Cost of capital is the expected rate of return that the market requires in order to attract funds to a particular investment," the author moves on to explore the most often used methods of estimating this cost. Emphasizing that cost of capital is both market-driven and forward-looking, measurement is based on market value in nominal terms as opposed to real terms. Nominal terms require the inclusion of expected inflation.

The author explains why net cash flow is the preferred measure of return before delving into the methods of estimating capital cost. These methods require an ability to grasp and understand some higher mathematical concepts, which are set forth in a relatively easy-to-read form with examples. Present value and discounting concepts are explained in order to better understand the models used to estimate the cost of capital. Models used to estimate the cost of each component of the capital structure include build up models, capital asset pricing model, discounted cash flow, three-factor model, and arbitrage pricing model.

A weighted average of each component of the organization's capital structure is computed when the overall cost of capital estimate is required. The author also gives insight into estimating risk and its influence on the cost of each component.

Cost of capital is a necessary input into corporate finance decisions and business valuations. Other applications include valuations of nonpublicly traded stock and the discount for nonmarketability, cost of capital estimation in shareholder disputes, tax disputes, reorganizations, damage cost disputes, and utility rate determinations.

A word of caution is in order. If espousing oneself as an expert in this field, it would be preferable to have a solid background and experience in capital markets. This requirement is not made explicit in the book. This minor omission is the only shortfall apparent to this reviewer. The author has successfully made a complex subject easier to understand. This book can serve as both a primer on cost of capital estimation and a reference book on estimation methods and applications. *