Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 44

Common Errors in Estimation and Use of Cost of Capital

Alina Niculita

Introduction

Confusing Discount Rates with Capitalization Rates

Substituting EBITDA for Net Cash Flow

Using Both the Discounting and Capitalizing Methods and Weighting Them

Using the Firm's Cost of Capital to Evaluate a More or Less Risky Acquisition or Project

Mistaking Historical Rates of Return for Expected Rates of Return

Blindly Accepting Morningstar's Long-term Average as Today's Equity Risk Premium

Using an Inconsistent Equity Risk Premium Estimate to That Used in the Industry Risk Premium

Using an Inappropriate Beta in the CAPM

Using an Inappropriate Beta in a Multifactor Model

Using a Safe Rate to Discount or Capitalize a Risky Return

Discounting a Risky Series of Returns by the T-bill Rate

Discounting Probability-weighted Cash Flows at the Risk-free Rate

Mismatching the Discount Rate with the Economic Income Measure

Applying a Discount Rate in Real Terms to an Economic Income Projection in Nominal (Current) Terms

Applying Costs of Capital Derived from After-tax Returns to Pretax Net Cash Flows

Adjusting Cost of Capital Derived from After-tax Returns to Pretax Discount Rate by Dividing by (1 – t)

Applying a Discount Rate Applicable to Net Cash Flow to Net Income

Discounting the Terminal Value for N + 1 Periods

Subtracting a Short-term Growth Rate from the Discount Rate to Get a Capitalization Rate

Performing an Excess Earnings Method Valuation That Results in an Unrealistic Cost of Capital ...