Chapter 10 • Cost of capital estimations and the discount rate
p 0 is the current ex-dividend price per share, that is, the price that does not
include the current year’s dividend.
lRetained profit automatically included as part of kE.Weighted average cost of capital (WACC)
lWACC (of a business with two types of finance, A and B) is:WACC =
lUse of WACC as discount rate requires three assumptions:
lbusiness has a target gearing ratio that will be maintained;
lcost of individual elements will remain constant; and
linvestments to be appraised are of similar risk to the general risk of the
business’s investments.Other issues
lSpecific cost of capital should not be used as the discount rate, even where an
investment is funded from that specific element – use WACC.
lWACC estimates cannot be seen as entirely accurate, due to the sweeping
assumptions that need to be made, particularly in estimating the cost of equity.
lAs normally estimated WACC tends to be forward-looking, which is appro-
priate when using it as the basis of the discount rate for assessing potential
investment opportunities.
lOf necessity, estimates of WACC are on a business-wide basis. This may pro-
vide a rate that is unsuitable for the discount rate for a particular project.
lOn the basis of the long-term average rate of return from equity investment,
it appears that some businesses may be seeking unreasonably high rates of
return for their investments.(kA×Value of A) +(kB×Value of B)
Value of A +BMost finance texts include fairly comprehensive treatment of the material discussed in this
chapter. Arnold (2005) gives an interesting coverage of it; Brealey, Myers and Allen (2007) deal
with it clearly and go into quite a lot of detail, particularly with regard to the costs of various
types of finance. Gregory, Rutterford and Zaman (1999) provide a very readable account of their
research into the cost of capital and of the background to this topic, including many insights
to how real businesses approach various aspects of investment decision making. The very
readable Dimson, Marsh and Staunton (2002) article, cited in the chapter, can be accessed and
downloaded at http://faculty.london.edu/edimson/Jacf1.pdf.Further
reading