The appropriate cost of capital for an investment is a common issue attorneys encounter in business appraisals for litigation, estate tax, gift tax, and bankruptcy as well as lost profits.
The cost of capital is arguably one of the most important concepts in all of finance. It is the essential link that allows one to convert a stream of expected income into its present or future value. Armed with the cost of capital, one can make informed decisions regarding the purchase or sale of assets and compare one investment opportunity to another through quantification.
The cost of capital is defined as the expected rate of return that the market requires in order to attract funds to a particular investment. In economic terms, the cost of capital for a particular investment is an opportunity cost — the cost of foregoing the next best alternative investment. In this sense, it relates to the economic principle of substitution; an investor will not invest in a particular asset if there is a more attractive substitute. The estimation of the cost of capital therefore is the pricing of risk, where small differences in risk pricing can result in significant differences in the conclusion of value.
The cost of capital is forward-looking and represents market expectations. The elements to these expectations are:
- The risk-free element, which reflects a risk-free rental rate, an inflationary component and investment rate risk; and
- The risk element, which reflects the uncertainty of the amount and timing of the cash flows from the investment.
The risk-free element can generally be observed in the marketplace by consulting published sources such as the Wall Street Journal, the U.S. Department of the Treasury’s Daily Treasury Yield Curve Rates, or the Federal Reserve’s H.15 (519) Selected Interest Rates. It is important to match the risk-free rate to the term of the investment.
In the case of business valuation, the term of the risk-free rate should match the term of the risk-free rate used to determine the equity risk premium. The equity risk premium is a rate of return added to a risk-free rate to reflect the additional risk of equity instruments over risk free instruments (a component of the cost of equity capital or equity discount rate). Traditionally, business appraisers use the 20-year Treasury Bond as a proxy for the risk-free rate.
The risk element reflects the uncertainty of expected returns from the investment and varies widely from one capital investment to another. The difference in uncertainty can be demonstrated by examining the rates of return on debt instruments with identical terms, but with different debt ratings (higher debt ratings indicate lower uncertainty and lower risk). The highest rated debt (S&P’s AAA rated or Moody’s Aaa rated) generally have lower interest rates than lower rated debt (S&P’s BB+ rated or Moody’s Ba1 rated). Investors demand a higher rate of return to account for higher risk.
There is typically much more uncertainty and risk with respect to the amount and timing of cash flows for equity investments than debt investments. Therefore, the cost of capital for equity investments is generally greater than the cost of capital for debt.
There are two generally accepted methods for estimating the expected cost of capital of equity, the capital asset pricing model (CAPM) and the build-up method (BUM), which have mostly similar inputs. The difference between CAPM and BUM is the treatment of industry-specific risk. CAPM utilizes beta, which is a measure of industry-specific risk as observed in the public markets; BUM incorporates this risk either within an industry risk premium (which is derived from Beta), or within the company-specific risk premium. The treatment of industry risk within BUM can result in differences between the company-specific risk premiums for both methods. The inputs to CAPM and BUM are summarized below:
Industry Risk Premium*
Equity Risk Premium
Equity Risk Premium
Company-Specific Risk Premium
Company-Specific Risk Premium
CAPM is perhaps the most widely used method for estimating the cost of equity capital. The Delaware Court of Chancery, which tends to hear cases involving large closely held companies and public companies, tends to prefer CAPM over BUM. The Tax Court has consistently excluded the use of CAPM when valuing small closely held companies with little possibility of going public. A search of Florida cases reveals only three cases where CAPM was used, and all of the cases involved utilities.
Therefore, while CAPM may be widely used elsewhere, in legal cases within Florida, as well as the Tax Court, the circumstances would have to be unique to apply CAPM when estimating the cost of capital when valuing small private companies.
Therefore, determining the appropriate model and the conclusion for the cost of capital of an investment can be a challenging endeavor. However, this issue can be paramount in the overall outcome of litigation because the conclusion of value can be very sensitive to small differences in the cost of capital.
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South Florida Legal Guide 2015 Edition