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10.1 Introduction
In Chapter 8 we took a brief look at typical sources of long-term finance of UK busi-
nesses. Now we shall see how it is possible to make estimates of the cost to the busi-
ness of each of these individual sources.
Since, logically, the discount rate to be applied to the expected cash flows of real
investment opportunities within the business should be the opportunity cost of
finance to support the investment, this discount rate must be related to the costs of
individual sources in some way. In fact, using an average cost of the various sources
of finance, weighted according to the importance of each source to the particular
business, seems to be regarded as a standard means of determining discount rates.
Evidence (Petty and Scott 1981; Corr 1983; Al-Ali and Arkwright 2000; Arnold and
Hatzopoulos 2000) suggests that this weighted average cost of capital(WACC)
approach is widely used in practice. McLaney, Pointon, Thomas and Tucker (2004)
found that WACC is used in investment appraisal by 53 per cent of UK listed busi-
nesses. They also found that nearly 80 per cent of businesses reassess their cost of cap-
ital annually or more frequently. As we shall see later in this chapter, many businesses
mention in their annual reports that they use WACC as the discount rate.
The standard approach to estimating the cost of specific sources of capital is based
on the logic that the discount rate is implied by the current value of the financial asset
concerned, and by future expectations of cash flows from that specific asset. This is a
popular approach in practice, although for estimating the cost of equity its popularity
is decreasing.Cost of capital estimations and
the discount rate
In this chapter we shall deal with the following:
‘estimating the cost of individual sources of capital
‘the difficulties of estimating the cost of equity finance
‘target gearing ratios
‘the weighted average cost of capital and its practical relevance as a
discount rateChapter 10
Objectives