The July/August issue of Harvard Business Review had an outstanding article ("Do you know your cost of capital?") on how the assumptions that leaders make can affect their cost of capital. In a nutshell, the article explains that "companies differ widely in the assumptions built into the financial models they use to evaluate investment opportunities... Not a single question about such assumptions received the same answer from a majority [>50%] of respondents."
Here are some highlights:
- What's your forecast horizon? 46% answered 5 years, 34% 10 years, 6% 15 years and 14% other.
- What's your cost of debt? 37% answered current rate on outstanding debt, 34% forecasted rate on new issuance, 29% average historical rate.
- What's the risk-free rate? 46% answered 10 years, 16% 90 days, 12% 5 years, 11% 30 years, 6% other, 5% 1 year and 4% 20 years.
- What's the equity-market risk premium? 49% answered 5%-6%, 23% 3%-4%, 17% 7% or greater and 11% less than 3%.
- What's your beta period? 41% answered 5 years, 29% 1 year, 15% 3 years, 13% 2 years and 2% other.
- What's your debt-to-equity ratio? 30% answered current book debt to equity, 28% targeted book debt to equity, 23% current market debt to equity and 19% current book debt to current market equity.
The article provides insights into what the correct answers should be, and hopefully corrects some misconceptions. Readers can visit this HBR-sponsored website (hosted by forio.com, which builds custom simulations and sells simulation development software to businesses, universities and government agencies) to test out their own data and calculate their cost of capital.