Estimation of Cost of Capital 107stock. Armed with adequate knowledge, investors feel more confident about their estimates of the company’s
value.
Only certain types of companies and certain kinds of information are able to lower the cost of capital.
Research in America shows that companies with a high market beta and larger analytical following, generally
pay more for the equity capital than others do.^8 Those results apply without regard to size or disclosure level.
On the other hand, companies that have little or no analytical coverage and that maintain a generous disclosure
policy enjoy 9 percent reduction in cost of equity when compared to the firm with the least amount of
disclosure. The results suggest that investors find the information a company provides to be most valuable
when they cannot turn to any outside analytical coverage. Which kind of information lowers the cost of
capital will depend largely on the extent of analytical coverage. Companies with little following enjoy the
largest decrease in the cost of equity when they disclose forward-looking information such as sales or earn-
ings forecasts. Companies with low analyst coverage might consider disclosing the impact of industry trends
on profits and sales, since these areas bear the greatest potential to improve the company’s cost of equity.
Cost of Capital Estimation in Select Companies^9
Digital Equipment Corporation is in the business of design, manufacture, sales and service of networked
computer systems, associated peripheral equipment and related network communication and software
products. The company applies hurdle rates based on a matrix concept shown here:
Any new product development effort along traditional lines (low risk) of the firm is evaluated at the
company’s weighted average cost of capital with no additional risk adjustment. As a project moves from
normal risk to areas of less traditional products or markets, or toward the more speculative (basic research)
end of the R&D spectrum, the company tries to quantitatively differentiate between different levels of project
risk by adjusting the hurdle rate to correspond to the level of systematic risk of the project risk. The pure play
technique is used to estimate the beta of a non-normal risk project. The proxy beta from a publicly traded,
single product line firm that competes in the targeted market place is used after adjusting for leverage (using
Hamada formulation). The CAPM and WACC formulas are then used to determine risk adjusted hurdle rate.
(^8) Botosan, Christine (2000), ‘Evidence that greater disclosure lowers the cost of equity’, Journal of Applied Corporate
Finance, Vol. 12, No. 4.
(^9) FMA round table discussion on cost of capital, Financial Management, Spring 1989.