Four Mistakes to Avoid 249
1.Privately owned firms. Our discussion of the cost of equity was related primar-
ily to publicly owned corporations, and we concentrated on the rate of return
required by public stockholders. However, there is a serious question about
how one should measure the cost of equity for a firm whose stock is not traded.
Tax issues are also especially important in these cases. As a general rule, the same
principles of cost of capital estimation apply to both privately held and publicly
owned firms, but the problems of obtaining input data are somewhat different
for each.
2.Small businesses. Small businesses are generally privately owned, making it diffi-
cult to estimate their cost of equity.
3.Measurement problems. One cannot overemphasize the practical difficulties
encountered when estimating the cost of equity. It is very difficult to obtain good
input data for the CAPM, for g in the formula rsD 1 /P 0 g, and for the risk pre-
mium in the formula rsBond yield Risk premium. As a result, we can never be
sure just how accurate our estimated cost of capital is.
4.Costs of capital for projects of differing riskiness. As we will see in Chapter 8,
it is difficult to measure projects’ risks, hence to assign risk-adjusted discount rates
to capital budgeting projects of differing degrees of riskiness.
5.Capital structure weights. In this chapter, we simply took as given the target cap-
ital structure and used this target to obtain the weights used to calculate WACC. As
we shall see in Chapter 13, establishing the target capital structure is a major task
in itself.
Although this list of problems may appear formidable, the state of the art in cost of
capital estimation is really not in bad shape. The procedures outlined in this chapter
can be used to obtain cost of capital estimates that are sufficiently accurate for practi-
cal purposes, and the problems listed here merely indicate the desirability of refine-
ments. The refinements are not unimportant, but the problems we have identified do
not invalidate the usefulness of the procedures outlined in the chapter.
Identify some problem areas in cost of capital analysis. Do these problems invali-
date the cost of capital procedures discussed in the chapter?
Four Mistakes to Avoid
We often see managers and students make the following mistakes when estimating the
cost of capital. Although we have discussed these errors previously at separate places in
the chapter, they are worth repeating here:
1.Never use the coupon rate on a firm’s existing debt as the pre-tax cost of
debt. The relevant pre-tax cost of debt is the interest rate the firm would pay if it
issued debt today.
2.WhenestimatingthemarketriskpremiumfortheCAPMmethod,neveruse
the historical average return on stocks in conjunction with the current risk-
free rate.The historical average return on common stocks has been about 13
percent,thehistoricalreturnonlong-termTreasurybondsabout5.5percent,andthe
difference between them, which is thehistoricalriskpremium,is 7.5 percent. The
currentriskpremiumis found as the difference between an estimate of the current
expectedrateofreturnoncommonstocksandthecurrentexpectedyieldonT-bonds.
Toillustrate,supposeanestimateofthefuturereturnoncommonstockis10percent,
and the current rate on long-term T-bonds is 4 percent. This implies that you expect
246 The Cost of Capital
