Are CFOs making ‘dangerous assumptions’ about their COC?

BVWireIssue #118-1
July 11, 2012

A new article, “Do You Know Your Cost of Capital?” by the Harvard Business Review Magazine, reports that 90% of top financial officers in companies use the CAPM to estimate their cost of equity, “but that is where the consensus ends.” Based on a recent survey of CFOs, the article posits that the “300 respondents probably don’t know as much about their cost of capital as they think they do,” and in fact, may be making some “dangerous assumptions” in putting together their financial models. For instance, “the miscalculations begin with the forecast periods,” the article says, and then extend to the terminal value, the cost of debt, the risk-free rate, the “equity market premium,” and the company-specific and project-specific risks.

What’s the danger in all these disparate assumptions? They may be leading to a woefully deficient deployment of capital in the current economy. “Despite record-low borrowing costs and record-high cash balances,” the article says, “capital expenditures by U.S. companies are projected to be flat or to decline slightly in 2012, indicating that most businesses are not adjusting their investment policies to reflect the decline in their cost of capital.” With over $2 trillion at stake in corporate coffers, “the hour has come for an honest debate about how best to determine investment time horizons, cost of capital, and project risk adjustment,” the article concludes. “And it is past time for nonfinancial corporate directors to get up to speed on how the companies they oversee evaluate investments.”

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