Recommended reading: Grabowski - Problems with Cost of Capital Estimation in the Current Environment

I just finished re-reading the article by Rober Grabowski titled "Problems with Cost of Capital Estimation in the Current Environment" (you can find it at: http://www.duffandphelps.com/sitecollectiondocuments/cost_capital_update_012909.pdf#page=1). I strongly recommend this article; one may not agree with everything written there, but it's a great food for thought and coming from such an eminent author - it's probably a "must read" for any BV professional. As for the contents - the title says it all. Just to sum it up quickly, here are some of the more interesting insights:

1. Stock market correction has been concentrated in stocks of financial and highly leveraged companies. So, traditional beta estimates provide us with wrong estimates of systematic risk going forward. Author suggests looking at a longer period and see how company's returns moved as compared to the overall market and see which period is the one from which to choose beta to use in our estimates of the riskiness of future cash flows. Author also suggests some alternative methods for estimating betas.

2. Currently risk-free rates are extremely low, leading to lower estimates of the cost of capital, which - in this environment - is counterintuitive. Author suggests using a longer term average T-bond yield (e.g. 4.5%) or a forward rate on T-bonds, at least until yields on T-bonds return to normal.

3. Equity risk premium (ERP) is cyclical. Author claimes long-term ERP is between 3.5 and 6.0 %. And during recessions it's more towards the upper end of the range. He suggests using 6.0% ERP, which can be expected to decrease in the future once economy rebounces.

4. Leverage: current D/E ratios are extremely high due to low market capitalizations. It's questionable also whether they are sustainable (WACC can be calculated using a changing capital structure). Furthermore, typical models of un- and re-levering betas do not work well in this economy, since they imply several assumptions (constant D/E, tax deductions on interest realized when interest is paid etc.) that are not realistic these days. So, alternative models should be used (e.g. Miles-Ezzell formula which also uses debt beta).

5. Financial distress is not incorporated into COEC calculation, so in case of companies in financial distress a premium should be added (e.g. one calculated by Duff&Phelps).

6. Value of tax shield: WACC should be calculated using a formula that takes into account the probability that income tax savings will not be realized in the period in which the interest is paid.

In the end it comes down to common sense - make sure you check the reasonableness of your cost of capital estimate. Duff&Phelps again provide data on historic equity returns based on companies' average operating margins and their variability.

As I said at the beginning, the article is great as it makes you think about the inputs you use in calculating the cost of capital. I agree with some of the propositions in this article, but might take issue with others in my further posts.