The Association of Financial Professionals recently released its 2013 AFP Estimating and Applying Cost of Capital Survey. The report is rather lengthy, but we would like to discuss some of the findings.
Eighty-five percent of the companies surveyed used discounted cash flow analysis for capital budgeting projects. For those of you who are worried about projecting cash flows far into the future, 51 percent of the companies used an explicit 5-year cash flow projection and 26 percent used an explicit 10-year cash flow projection. After that estimation period, a terminal valuation is used to account for cash flows beyond that period. Additionally, 72 percent of companies used scenario analysis when evaluating a new project.
When estimating the cost of equity, 85 percent of companies use the CAPM. The choice of the risk-free rate is varied, with 39 percent using the 10-year Treasury, which is not consistent with our choice. There is also a disparity in practice whether to apply the current, historical, or forward risk-free rate. The choice of beta is also widely varied, with companies choosing different sources, estimation periods, return frequency, adjustment of the estimated beta toward one, and delevering and relevering beta.
As we discussed in the textbook, many argue that the market risk premium since 1926 is unsustainable going forward. The survey results show the variation in the market risk premium used. Seventeen percent of companies use a market risk premium of 3 percent or less, while 19 percent use a market risk premium of 6 percent or more. One thing we should mention about the market risk premium relates back to the choice of the Treasury used to proxy the risk-free rate. The choice of a longer term Treasury over a shorter term Treasury would result in a lower market risk premium, assuming an upward sloping yield curve. Because the choice of which Treasury maturity should proxy the risk-free rate is directly related to the market risk premium, interpreting the results of this question in isolation is problematic.
Finally, for those students who feel that they are struggling with finance, rest assured that you are not alone. We would fail the 36 percent of the companies in this survey who use the current book value debt/equity ratio. As we mentioned numerous times, book values are not useful in most instances, but rather market values should be used. However, the 17 percent of companies that use the current book debt/current market equity ratio for the capital structure weights would pass our classes since the book value and market value of debt are generally close.
