January 2019 Data Update 5: Hurdle Rates and Costs of Financing

In the last post, I looked at how to measure risk from different perspectives, with the intent of bringing these risk measures into both corporate finance and valuation. In this post, I will close the circle by converting risk measures into hurdle rates, critical in corporate finance, since they drive whether companies should invest or not, and in valuation, because they determine the values of businesses. As with my other data posts, the focus will remain on what these hurdle rates look like for companies around the world at the start of 2019.

A Quick Introduction

The simplest way to introduce hurdle rates is to look at them from the perspectives of the capital providers to a business. Using a financial balance sheet as my construct, here is a big picture view of these costs:

Thus. the hurdle rate for equity investors, i.e., the cost of equity, is the rate that they need to make, to break even, given the risk that they perceive in their equity investments. Lenders, on the other hand, incorporate their concerns about default risk into the interest rates they set on leans, i.e., the cost of debt. From the perspective of a business that raises funds from both equity investors and lenders, it is a weighted average of what equity investors need to make and what lenders demand as interest rates on borrowing, that represents the overall cost of funding, i.e., the cost of capital.

I have described the cost of capital as the Swiss Army Knife of finance, used in many different contexts and with very different meanings. I have reproduced below the different uses in a picture:

Paper on cost of capital

It is precisely because the cost of capital is used in so many different places that it is also one of the most misunderstood and misused numbers in finance. The best way to reconcile the different perspectives is to remember that the cost of capital is ultimately determined by the risk of the enterprise raising the funding, and that all of the many risks that a firm faces have to find their way into it. I have always found it easiest to break the cost of capital into parts, and let each part convey a specific risk, since if I am careless, I end up missing or double counting risk. In this post, I will break the risks that a company faces into four groups: the business or businesses the company operates in (business risk), the geographies that it operates in (country risk), how much it has chosen to borrow (financial leverage risk) and the currencies its cash flows are in (currency effects). 

Note that each part of the cost of capital has a key risk embedded in it. Thus, when valuing a company, in US dollars, in a safe business in a risky country, with very little financial leverage, you will see the 10-year US treasury bond rate as my risk free rate, a low beta (reflecting the safety of the business and low debt), but a high equity risk premium (reflecting the risk of the country).  The rest of this post will look at each of the outlined risks.

I. Business Risk
In my last post, where I updated risk measures across the world, I also looked at how these measures varied across different industries/businesses. In particular, I highlighted the ten most risky and safest industries, based upon both price variability and earnings variability, and noted the overlap between the two measures. I also looked at how the perceived risk in a business can change, depending upon investor diversification, and captured this effect with the correlation with the overall market.  If you are diversified, I argued that you would measure the risk in an investment with the covariance of that investment with the market, or in its standardized form, its beta.

To get the beta for a company, then, you can adopt one of two approaches.

• The first, and the one that is taught in every finance class, is to run a regression of returns on the stock against a market index and to use the regression beta. 
• The second, and my preferred approach, is to estimate a beta by looking at the business or businesses a company operates in, and taking a weighted average of the betas of companies in that business. 

To use the second approach, you need betas by business, and each year, I estimate these numbers by averaging the betas of publicly traded companies in each business. These betas, in addition to reflecting the risk of the business, also reflect the financial leverage of companies in that business (with more debt pushing up betas) and their holdings in cash and marketable securities (which, being close to risk less, push down betas). Consequently, I adjust the average beta for both variables to estimate what is called a pure play or a business beta for each business. (Rather than bore you with the mechanics, please watch this video on how I make these adjustments). The resulting estimates are shown at this link, for US companies. (You can also download the spreadsheets that contain the estimates for other parts of the world, as well as global averages, by going to the end of this post).

To get from these business betas to the beta of a company, you need to first identify what businesses the company operates in, and then how much value it derives from each of the businesses. The first part is usually simple to do, though you may face the challenge of finding the right bucket to put a business into, but the second part is usually difficult, because the individual businesses do not trade. You can use revenues or operating income by business as approximations to estimate weights or apply multiples to each of these variables (by looking at what other companies in the business trade at) to arrive at value weights. 

II. Financial Leverage

You can run a company, without ever using debt financing, or you can choose to borrow money to finance operations. In some cases, your lack of access to new equity may force you to borrow money and, in others, you may borrow money because you believe it will lower your cost of capital. In general, the choice of whether you use debt or equity remains one of the key parts of corporate finance, and I will discuss it in one of my upcoming data posts. In this post, though, I will just posit that your cost of capital can be affected by how much you borrow, unless you live in a world where there are no taxes, default risk or agency problems, in which case your cost of capital will remain unchanged as your funding mix changes.  If you do borrow money to fund some or a significant portion of your operations, there are three numbers that you need to estimate for your cost of capital:

1. Debt Ratio: Th mix of debt and equity that you use represents the weights in your cost of capital.
2. Beta Effect: As you borrow money, your equity will become riskier, because it is a residual claim, and having more interest expenses will make that claim more volatile. If you use beta as your measure of risk, this will require you to adjust upwards the business (or unlettered) beta that you obtained in the last part, using the debt to equity ratio of the company. 
   
3. Cost of Debt: The cost of debt, which is set by lenders based upon how much default risk that they see in a company, will enter the cost of capital equation, with an added twist. To the extent that the tax law is tilted towards debt, the after-tax cost of borrowing will reflect that tax benefit. Since this cost of debt is a cost of borrowing money, long term and today, you cannot use a book interest rate or the interest rate on existing debt. Instead, you have to estimate a default spread for the company, based upon either its bond ratings or financial ratios, and add that spread on to the risk free rate:
   

I look at the debt effect on the cost of capital in each of the industries that I follow, with all three effects incorporated in this link, for US companies. The data, broken down, by other regional sub-groupings is available at the end of this post.

III. Country Risk
It strikes me as common sense that operating in some countries will expose you to more risk than operating in others, and that the cost of capital (hurdle rate) you use should reflect that additional risk. While there are some who are resistant to this proposition, making the argument that country risk can be diversified by having a global portfolio, that argument is undercut by rising correlations across markets. Consequently, the question becomes not whether you should incorporate country risk, but how best to do it. There are three broad choices:

1. Sovereign Ratings and Default Spreads: The vast majority of countries have sovereign ratings, measuring their default risk, and since these ratings go with default spreads, there are many who use these default spreads as measures of country risk. 
2. Sovereign CDS spreads: The Credit Default Swap (CDS) market is one where you can buy insurance against sovereign default, and it offers a market-based estimate of sovereign risk. While the coverage is less than what you get from sovereign ratings, the number of countries where you can obtain these spreads has increased over time to reach 71 in 2019. 
3. Country Risk Premiums: I start with the default spreads, but I add a scaling factor to reflect the reality that equities are riskier than government bonds to come up with country risk premiums. The scaling factor that I use is obtained by dividing the volatility of an emerging market equity index by the volatility of emerging market bonds. 

To incorporate the country risk into my cost of capital calculations, I start with the implied equity risk premium that I estimated for the US (see my first data post for 2019) or 5.96% and add to it the country risk premium for each country. The full adjustment process is described in this picture:

I also bring in frontier markets, which have no sovereign ratings, using a country risk score estimated by Political Risk Services. The final estimates of equity risk premiums around the world can be seen in the picture below:

You can see these equity risk premiums as a list by clicking here, or download the entire spreadsheet here. If you prefer a picture of equity risk around the world, my map is below:

Download spreadsheet

I also report regional equity risk premiums, computed by taking GDP-weighted averages of the equity risk premiums of the countries int he region.

IV. Currency Risk
It is natural to mix up countries and currencies, when you do your analysis, because the countries with the most risk often have the most volatile currencies. That said, my suggestion is that you keep it simple, when it comes to currencies, recognizing that they are scaling or measurement variables rather than fundamental risk drivers. Put differently, you can choose to value a Brazilian companies in US dollars, but doing so does not make Brazilian country risk go away.

So, why do currencies matter? It is because each one has different expectations of inflation embedded in it, and when using a currency, you have to remain inflation-consistent. In other words, if you decide to do your analysis in a high inflation currency, your discount rate has to be higher, to incorporate the higher inflation, and so do your cash flows, for the same reason:

There are two ways in which you can bring inflation into discount rates.  The first is to use the risk free rate in that currency as your starting point for the calculation, since risk free rates will be higher for high inflation currencies. The challenge is finding a risk free investment in many emerging market currencies, since even the governments bonds, in those currencies, have default risk embedded in them. I attempt to overcome this problem by starting with the government bond but then netting the default spread for the government in question from that bond to arrive at risk free rates:

Download raw data

These rates are only as reliable as the government bond rates that you start with, and since more than two thirds of all currencies don't even have government bonds and even on those that do, the government bond rate does not come from liquid markets, there a second approach that you can use to adjust for currencies. In this approach, you estimate the cost of capital in a currency that you feel comfortable with (in terms of estimating risk free rates and risk premiums) and then add on or incorporate the differential inflation between that currency and the local currency that you want to convert the cost of capital to. Thus, to convert the cost of capital in US $ terms to a different currency, you would do the following:

To illustrate, assume that you have a US dollar cost of capital of 12% for an Egyptian company and that the inflation rates are 15% and 2% in Egyptian Pounds and US dollars respectively:

The Egyptian pound cost of capital is 26.27%. Note that there is an approximation that is often used, where the differential inflation is added to the US dollar cost of capital; in this case your answer would have been 25%. The key to this approach is getting estimates of expected inflation, and while every source will come with warts, you can find the IMF's estimates of expected inflation in different currencies at this link.

General Propositions
Every company, small or large, has a hurdle rate, though the origins of the number are murky at most companies. The approach laid out in this post has implications for how hurdle rates get calculated and used.

1. A hurdle rate for an investment should be more a reflection the risk in the investment, and less your cost of raising funding: I fault terminology for this, but most people, when asked what a cost of capital is, will respond with the answer that it is the cost of raising capital. In the context of its usage as a hurdle rate, that is not true. It is an opportunity cost, a rate of return that you (as a company or investor) can earn on other investments in the market of equivalent risk. That is why, when valuing a target firm in an acquisition, you should always use the risk characteristics of the target firm (its beta and debt capacity) to compute a cost of capital, rather than the cost of capital of the acquiring firm.
2. A company-wide hurdle rate can be misleading and dangerous: In corporate finance, the hurdle rate becomes the number to beat, when you do investment analysis. A project that earns more than the hurdle rate becomes an acceptable one, whether you use cash flows (and compute a positive net present value) or income (and generate a return greater than the hurdle rate). Most companies claim to have a corporate hurdle rate, a number that all projects that are assessed within the company get measured against. If your company operates in only one business and one country, this may work, but to the extent that companies operate in many businesses across multiple countries, you can already see that there can be no one hurdle rate. Even if you use only one currency in analysis, your cost of capital will be a function of which business a project is in, and what country it is aimed at. The consequences of not making these differential adjustments will be that your safe businesses will end up subsidizing your risky businesses, and over time, both will be hurt, in what I term the "curse of the lazy conglomerate".
3. Currency is a choice, but once chosen, should not change the outcome of your analysis: We spend far too much time, in my view, debating what currency to do an analysis in, and too little time working through the implications. If you follow the consistency rule on currency, incorporating inflation into both cash flows and discount rates, your analyses should be currency neutral. In other words, a project that looks like it is a bad project, when the analysis is done in US dollar terms, cannot become a good project, just because you decide to do the analysis in Indian rupees. I know that, in practice, you do get divergent answers with different currencies, but when you do, it is because there are inflation inconsistencies in your assessments of discount rates and cash flows.
4. You cannot (and should not) insulate your cost of capital from market forces: In both corporate finance and investing, there are many who remain wary of financial markets and their capacity to be irrational and volatile. Consequently, they try to generate hurdle rates that are unaffected by market movements, a futile and dangerous exercise, because we have to be price takers on at least some of the inputs into hurdle rates. Take the risk free rate, for instance. For the last decade, there are many analysts who have replaced the actual risk free rate (US 10-year T.Bond rate, for instance) with a "normalized' higher number, using the logic that interest rates are too low and will go up. Holding all else constant, this will push up hurdle rates and make it less likely that you will invest (either as an investor or as a company), but to what end? That uninvested money cannot be invested at the normalized rate, since it is fictional and exists only in the minds of those who created it, but is invested instead at the "too low" rate. 
5. Have perspective: In conjunction with the prior point, there seems to be a view in some companies and for some investors, that they can use whatever number they feel comfortable with as hurdle rates. To the extent that hurdle rates are opportunity costs in the market, this is not true. The cost of capital brings together all of the risks that we have listed in this section. If nothing else, to get perspective on what comprises high or low, when it comes to cost of capital, I have computed a histogram of global and US company costs of capital, in US $ terms.
   
   
   You can convert this table into any currency you want. The bottom line is that, at least at the start of 2019, a dollar cost of capital of 14% or 15% is an extremely high number for any publicly traded company. You can see the costs of capital, in dollar terms, for US companies at this link, and as with betas, you can download the cost of capital, by industry, for other parts of the world in the data links below this post.

In short, if you work at a company, and you are given a hurdle rate to use, it behooves you to ask questions about its origins and logic. Often, you will find that no one really seems to know and/or the logic is questionable.

YouTube Video


Data Sets

1. Betas by Business: US, Global, Emerging Markets, Europe, Japan, India, China, Aus & Canada
2. Sovereign Ratings and CDS Spreads by Country in January 2019
3. Equity Risk Premiums by Country in January 2019
4. Risk free Rates by Currency: Government bond based
5. Cost of Capital in US $ (with conversion equation for other currencies): US, Global, Emerging Markets, Europe, Japan, India, China, Aus & Canada

January 2019 Data Updates

1. Data Update 1: A Reminder that equities are risky, in case you forgot!
2. Data Update 2: The Message from Bond Markets
3. Data Update 3: Playing the Numbers Game
4. Data Update 4: The Many Faces of Risk
5. Data Update 5: Of Hurdle Rates and Funding Costs!
6. Data Update 6: Profitability and Value Creation!
7. Data Update 7: Debt, neither poison nor nectar!
8. Data Update 8: Dividends and Buybacks - Fact and Fiction!
9. Data Update 9: Playing the Pricing Game!

Read More

January 2018 Data Update 8: Debt and Taxes

In the United States, as in much of the rest of the world, and as has been true for most of the last century, the tax code has been tilted towards debt, rewarding firms that borrow money with tax savings, relative to those that use equity to fund their operations. While the original rationale for this debt bias was to allow the large infrastructure companies of the equity markets (railroads, followed by phone and natural resource companies) to raise financing to fund their growth, that reason has long dissipated, but a significant segment of the economy is built on debt. The most revolutionary component of the US tax reform package that passed at the end of last year is that it reduces the benefits of debt in multiple ways, and by doing so, challenges companies that have long depended on debt to reexamine their financing policies. 

The Trade Off on Debt and the Tax Reform Package

In last year’s update on debt, I summarized the trade off on debt, listing both the real pluses and minuses of debt as well as what I called the illusory benefits. In the latter group, I included reasons like debt is cheaper than equity and dilution benefits:

The bottom line is that it is the tax advantage of debt that makes it attractive to equity, and the benefits to borrowing were greater in the United States than in any other country last year, for a simple reason. The US had the highest marginal corporate tax rate in the world, at 40%, and companies that borrowed effectively claimed their tax benefits at that rate. To the oft touted counter that no US companies pay 40%, that is true, but it actually makes the tax benefit of debt even more perverse. Companies in the United States have been able to pay effective tax rates well below 40%, while maximizing their tax benefits from debt. As an example, consider Apple, which paid an effective tax rate of less than 25% on its global income last year, partly because it left so much of its foreign income off shore (as trapped cash). Apple still managed to borrow almost $110 billion in the United States, and claim the interest expenses on that debt as a tax deduction against its highest taxed income (its US income). For those of you who find this unethical, please spare me the moralizing since your disdain should be directed at those who wrote the tax code.

As I noted in my post on the changes that tax reform is bringing, the biggest are going to be to the tax benefits of debt, which will be dramatically decreased starting this year, for two reasons:

1. Lower marginal tax rate: The marginal tax rate for the United States has gone from being the highest in the world to close to the middle. At a 24% marginal tax rate, which is where I think we will end up with state and local taxes added to the new federal tax rate of 21%, you are effectively reducing the tax benefit of debt by about 40% (from 40% to 24%). In the heat map below, I have highlighted marginal tax rates of countries, with a highlighting in shades of rec of those that will have lower marginal tax rates than the US after 2018. To provide a contrast, this picture would have been entirely in shades of red last year, before the tax rate change, since there was no other country with a corporate tax higher than 40%.

via chartsbin.com
2. Limits on interest tax deductions: Until last year, as has been the case for much of the last century, US companies have been able to claim their interest expenses as tax deductions, as long as they have the income to cover these expenses. With the new tax code, there is a limit to how much interest you can deduct, at 30% of adjusted taxable income. Any excess interest expenses that cannot be deducted can be carried forward and claimed in future years, and that provision will help companies with volatile earnings, since they will be able to claim back deductions lost in a bad year, in good years. As is its wont, Congress has chosen to make up its own definitions of adjusted taxable income, with EBITDA standing on for operating income until 2021 and then transitioning to earnings before interest and taxes (EBIT). 

There are two other provisions in the tax code which will also indirectly affect the debt trade off.

1. Capital Expensing: Attempting to encourage investments in physical assets, especially at manufacturing companies, the tax code will allow companies to expense their capital investments for a temporary period. The resulting tax deductions may be large enough to reduce the benefit to having the interest tax deduction. That effect will be magnified by the fact that the companies that are most likely to be using the capital expensing provisions are also the companies that have used debt the most in funding their operations.
2. Un-trapped Cash: As companies are allowed to pay a one-time tax and bring trapped cash back to the United States, the cash will be now available for other uses and reduce the need for debt as a funding source. Note that estimates of this trapped cash, collectively held by US companies, exceed $3 trillion and that even if only half of this cash is brought back, it would still be a substantial amount.

All in all, there are multiple provisions in the tax code that handicap the use of debt and very few, perhaps even none, that would make debt a more attractive source of financing. 

Optimal Capital Structure

To quantify the impact of the tax code’s change on how much debt a company should have and how much value it adds, I used an old but flexible optimizing tool: the cost of capital. It is, of course, the number around which a post looking at how it varies around the world and sectors. In the follow up post, I used the cost of capital as a hurdle rate to judge the quality of a company’s investments. In this one, I will use it to talk about the right mix of debt and equity, and how it affects value:

Note that as you borrow more money, your costs of equity and debt go into motion, increasing as the debt increases and the trade off from the last section plays out, with the tax benefits showing up as an after-tax cost of debt and the bankruptcy costs partially captured in the higher costs of both equity and debt and partially as drops in operating income. Note that the key changes in the 2017 tax reform package, at least as they relate to the trade off, are highlighted. I used Disney as an illustrative example, and computed the costs of capital at every debt ratio under the old tax regime and the new one and the results are in the graph below:

Disney Capital Structure Spreadsheet

The cost of capital is a driver of the value of the operating assets, and since the costs of capital are higher at every debt ratio than they used to be, it should come as no surprise that the value added by debt has dropped at every debt ratio, with the new tax code.

Download spreadsheets: Disney, Facebook & Ford

The easiest way to see the effects of the new tax code are to look at how it plays out in the cost of capital and values of real companies. I will use Facebook, Disney and Ford as my examples, partly because they are all high profile and partly because they have widely divergent current debt policies, with Facebook having almost no debt, Disney a moderate amount and Ford more debt. With each firm, I computed the schedule of cost of capital, holding all else constant (both micro variables like EBIT and EBITDA and macro variables like the risk free rate and ERP.), with the old and new tax codes. I do this, not because I believe that these numbers will not be affected by the tax code, but because I want to isolate its impact on debt. 

For all three firms, the effect of the new tax code is unambiguous. The value added by debt drops with the new tax code and the change is larger at higher debt ratios. Taking away 40% of the tax benefits of debt (by lowering the marginal tax rate from 40% to 24%) has consequences. Note, though, that the lost value is almost entirely hypothetical, for Facebook, since it did not borrow money even under the old code and did not have much capacity to add value from debt in the first place. It is large, for Disney and Ford, as existing debt becomes less valuable, with the new tax reform. Note, though, that both companies will also benefit from the tax code changes, paying lower taxes on income both domestically, with the lowering of the US tax rate, and on foreign income, from the shift to a regional tax model. Ford, in particular, could also benefit from the capital expensing provision. My guess is that both firms will see a net increase in value, with all changes incorporated. With these three firms, at least, the cap on the interest expense deduction (set at 30% of EBITDA for the near term) does not affect value at their existing debt ratios and is not a binding constraint until they get to very high debt ratios. 

Debt Ratios- Cross Sectional Distributions

If you accept my reasoning that the new tax code will lower the value of debt in capital structure, and that the effect will be most visible at firms that borrowed a lot of money under the old tax regime, the only way to assess the tax code’s impact is to look how debt ratios vary across companies, and what type of firms and in what sectors borrow the most.

To get a measure of what comprises a high debt ratio, I started by looking at the distribution of debt ratios across companies, for both US and global companies:

I was surprised by how many firms in the global sample have little or no debit their capital structure, with more than half of all firms in the sample having total debt to capital ratios of less than 10%. In fact, netting cash out from debt would lead to even lower net debt ratios. That said, there is enough debt at the largest firms that the aggregated debt ratios across all firms is significantly higher. Looking at these aggregated debt ratios, you would expect US companies to have been borrowing more money than companies in other parts of the world, and to see if they did, I looked at measures of financial leverage, from debt scaled to capital to debt to EBITDA globally:

Sub Group	Debt/Capital (Book)	Debt/Capital (Market)	Net Debt/ Capital (Book)	Net Debt/ Capital (Market)	Debt/EBITDA
Africa and Middle East	45.23%	34.00%	30.27%	21.31%	5.99
Australia & NZ	61.66%	43.48%	57.82%	39.60%	8.57
Canada	55.35%	42.42%	52.46%	39.60%	7.16
China	51.63%	39.34%	41.83%	30.40%	8.52
EU & Environs	60.75%	47.17%	53.68%	40.07%	7.78
Eastern Europe & Russia	31.02%	38.05%	21.35%	27.05%	2.47
India	54.89%	20.85%	50.58%	18.15%	3.92
Japan	56.16%	49.11%	27.64%	22.35%	7.61
Latin America & Caribbean	51.67%	40.01%	46.23%	34.90%	5.74
Small Asia	44.04%	34.76%	36.01%	27.59%	4.54
UK	63.74%	46.39%	53.68%	36.33%	7.94
United States	64.06%	37.11%	60.86%	33.99%	7.09

The results are mixed. While US companies look like they are the most highly levered in the world, if you scale debt (gross and net) to book value, US companies don’t look like outliers on any of the dimensions. In fact, the only real outliers seem to be East European companies that borrow far less than the rest of the world, relative to EBITDA, and Indian companies, that borrow less, relative to market value. Looking across sectors, you do see clear differences, with some sectors almost completely unburdened with debt and others less so. While you can get the entire list from clicking on this link, the most highly levered sectors in the US are highlight below, relative to both market capital and EBITDA.

Download full sector spreadsheet

I removed financial service firms from this list, since debt to them is a raw material, not a source of capital, and real estate investment trusts, since they do not pay corporate taxes, under the old and new tax regimes. As I noted in my post on tax reform, it is the most highly levered sectors that will be exposed to loss of value and it is entirely possible that the net effect of the tax change can be negative for them. 

Implications
You seldom get to observe a real world experiment of the magnitude that we will be faced with in 2018, with the tax code in change and the loss in value added from debt. Given the changes, I would expect the following:

1. Deleveraging at firms that have pushed to their optimal debt ratios, under old tax code: While there are many firms, like Facebook. where debt was never a source of added value, where the tax code will affect that component of value very little, there will be other highly levered firms where the value change will be substantial. In fact, many of these firms, which would have been at the right mix of debt and equity, under the old tax regime, will find themselves over levered and in need of paying down debt. Given that inertia is the primary force in corporate finance, it may them a while to come to this realization.
2. Go slow at firms that have held back: For firms like Facebook that have held back from borrowing, under the old tax code, the new tax code reduces the incentive to add to debt, even as they mature. As you can see from the numbers on Facebook, Disney and Ford, the benefits of debt have been significantly scaled down.
3. Transactions that derive most of their value from leverage will be handicapped: Since the mid-1980s, leveraged transactions have been favored by many private equity investors. While one reason was that they were equity constrained (and that reason remains), the bigger reason was that it allowed them to generate added value from recapitalization. At the risk of over generalizing, I will argue that for a large segment of private equity investors, this was the primary source of their value added and for these investors, the new tax code is unequivocally bad news, and I will shed no tears for them. 

As I noted at the start of this post, debt is part of the fabric of business in the United States, and there are some businesses and asset classes that have been built on debt. Real estate and infrastructure businesses have historically not only used debt as a primary source of funding but as a value addition, with the added value coming from the tax code. Now that the added value is much lower, it remains to be seen whether asset values will have to adjust.

Conclusion
From financial first principles, there is nothing inherently good or bad about debt. It is a source of financing that you can use to build a business, but by itself, it neither adds nor detracts from the value of the business. It is the addition of tax benefits and bankruptcy costs that makes the use of debt a trade off between its benefits (primarily tax driven) and its costs (from increased distress and agency costs). The new tax code has not removed the tax benefits of debt but it has substantially reduced them, and we should expect to see less debt overall at companies, as a consequence. In my view, that is a positive for the economy, since debt magnifies economic shocks to businesses and not only creates more volatile earnings and value, but deadweight costs for society.

YouTube Video


Datasets

1. Debt Ratios by Sector, US (January 2018)
2. Debt Ratios by Sector, Global (January 2018)

Spreadsheets

1. Capital Structure Optimizing Spreadsheet (with 2017 US Tax Code changes built in) (with YouTube guide to using this spreadsheet)
2. Disney Optimal Capital Structure 
3. Facebook Optimal Capital Structure
4. Ford Optimal Capital Structure

Data Update Posts

1. January 2018 Data Update 1: Numbers don't lie, or do they?
2. January 2018 Data Update 2: The Buoyancy of US Equities!
3. January 2018 Data Update 3: Taxing Questions on Value
4. January 2018 Data Update 4: The Currency Conundrum
5. January 2018 Data Update 5: Country Risk Update
6. January 2018 Data Update 6: A Cost of Capital Primer
7. January 2018 Data Update 7: Growth and Value - Investment Returns
8. January 2018 Data Update 8: Debt and Taxes
9. January 2018 Data Update 9: Dividends, Buybacks and Cash Holdings
10. January 2018 Data Update 10: The Price is Right!

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January 2018 Data Update 6: A Cost of Capital Primer

I have long described the cost of capital as the Swiss Army Knife of finance, since it shows up in so many places in finance, albeit in different forms. In corporate finance, it is not only the cost of raising funding for a business but also the hurdle rate to use in capital budgeting and an optimizing tool for capital structure and dividend policy. In valuation, it is the discount rate that we use to value a business and the only mechanism for incorporating the risk of a business into its value. Along the way, it picks up a variety of other names that are used to describe it (with my least favorite one being the WACC acronym) and gets confused or used interchangeably with the cost of equity. In short, it is not surprising that there seems to be little consensus on how to estimate the cost of capital for a business.

The Cost of Capital: Definition

It is unfortunate that the name that we have attached to this ubiquitous number is the cost of capital, since it seems to suggest that it is the cost of raising funding for a company. While that definition may sometimes fit, it often leads to destructive consequences, where companies that are safe and can raise equity or borrow money at low rates (and hence have a low cost of funding) think that they are adding value when they go out and take risky investments that earn more than that cost. A company that has a 5% cost of capital is not always adding value if it takes an investment that generates an 8% return, if the investment is risky enough to require a much higher return. A healthier definition of the cost of capital is to think of it as an opportunity cost, i.e., a rate of return that you (as an investor or by extension, a company that the investor has put money in) can make on an investment of equivalent risk. The key words in this definition are "equivalent risk", because that effectively eliminates the subsidy mistake that occurs when a safe company's cost of capital is used to justify taking a risky investment. This is, of course, one of the first principles of finance and it is astonishing that it is open for debate and that so many companies violate it, in their practices. If you are skeptical of my claim, consider the following manifestations of this malpractice:

1. Many multi-business companies continue to have a "single" hurdle rate in capital budgeting: In a survey of "best" practices across companies and advisors, the authors note that almost half of all companies (and advisors) surveyed used a single cost of capital across all investments.  That is not only not good practice, but over time, it will ensure that your entire company will become a riskier company that takes bad investments. While I appreciate the work that went into this survey, I would suggest that the authors seriously reconsider using the word "best" to describe many of the horrendous practices that companies use in computing cost of capital. Looking at surveys of how companies compute costs of capital around the world, it seems clear to me that  bad practices drive out good ones, a manifestation of Gresham's law in corporate finance practice.
2. In acquisitions, it is routine for companies (and bankers) to use the acquiring company's cost of capital to value the target company: While I cannot point to surveys to back up this statement, in my experience, this happens in more than 60% of acquisitions, with the logic being that it is the acquiring firm that raises the capital and that its costs should therefore be covered. The fact that will lead safe firms to find any risky firm that they look at to be cheap is glossed over. If you are waffling, let me be absolutist. Valuing a target company using an acquiring company's cost of capital is valuation malpractice, and if you do it, you should be stripped of your license to do valuation.
3. Cash is viewed as a value destroying asset: If you follow GAAP or IFRS, for an asset to be categorized with cash and short term investments, it has to be invested in liquid and close to riskless assets. In the last decade, these investments, not surprisingly, have generated extraordinarily low returns, but it is true, no matter what interest rate environment you are in, that cash will earn lower returns than operating investments. There are analysts, and I use the word loosely, who compare the returns generated on cash to the cost of capital of the firm to conclude that cash is a value-destroying asset and that it should be returned. While there are legitimate arguments that can be made that companies should return cash to stockholders, this is not one of them. In fact, cash, if invested in treasury bills or commercial paper, is a value-neutral investment, earning exactly the return that you need it to earn, given its liquid, diskless status.
4. A company that earns a higher return on its projects (higher ROIC) should be valued more highly than a company that earns a lower return on its projects: Without controlling for risk, this is not true. In fact, the right assessment would require comparing the ROIC to the cost of capital to estimate an excess return and a company that earns a higher positive excess return should be valued more highly than one that earns a lower excess return.

The key, then, to estimating cost of capital is to to link it directly to a risk measure that can be computed not just for entire companies but for individual projects. It is that pursuit that will drive my estimation process for cost of capital, described in the next section.

The Cost of Capital: Estimation Process

There are ultimately only two ways of raising funds to finance a business. One is to borrow the money (debt) and the other is to use your own money (equity). This is captured in one of my favorite corporate finance devices, the financial balance sheet:

With a small private business, the debt will take the form of a bank loan and the equity will be your savings, but as businesses scale up, debt may expand to include corporate bonds and equity may transition to venture capital, private equity and publicly traded stock. The structure also allows us to boil the cost of capital down to its three ingredients: a cost of equity, an after-tax cost of debt and the weights to attach to the two.

Cost of equity

The End game: In principle, the cost of equity is the rate of return that equity investors in your business need to make to compensate for the risk that they are exposed to.

The Practice:  For the last few decades, corporate finance has tried, with mixed success, to devise a risk and return model to estimate the cost of equity. While these models vary in complexity and inputs, they generally share a common theme. They estimate the cost of equity to the marginal investors in the business, i.e., investors who own and trade large blocks of shares, and assume that these investors are diversified. These models all share a common structure; they start with a risk free rate and then estimate a risk premium for an investment, by measuring its relative risk (on one or more market risk factors) and the price of risk or risk premiums (for these factors). While it is the subject of substantial abuse, the capital asset pricing model continues to be the default model that most practitioners use in estimating cost of equity. The resulting inputs are shown below:

I still use the capital asset pricing model in my valuations and I offer no apologies for doing so, since I find it simple, intuitive and at least as effective as the next best alternative models, most of which add more complexity and deliver little in results.  For those who are truly disturbed by the CAPM's limitations, there is an alternative approach worth considering that is agnostic in its assumptions about investor diversification and risk aversion. It is to back out the "implied" cost of equity for stocks within a sector and to use that implied number as the cost of equity in individual companies. If you are puzzled about what this implies, take a look at how I estimated the implied equity risk premium for the S&P 500 in my second data post from a couple of weeks ago and consider extending that approach to the banking index, to get an implied cost of equity for banks, and the energy sector, to estimate the cost of equity for oil companies.

Cost of Debt

The End Game: The cost of debt for a firm is the rate at which it can borrow money, long term and today. The after-tax cost of debt is this borrowing rate, adjusted for any tax benefits that accrue to borrowing money.

The Practice: By defining the cost of debt as a current cost of borrowing, rather than the rate at which the firm has borrowed money in the past, I have simplified my estimation problem, since the cost of debt can then be written as the sum of the riskless rate and a default spread, reflecting the company's credit risk:

Pre-tax cost of debt = Risk free Rate + Default Spread for the Company

To estimate the default spread, you can use one of three approaches, in order of ease.

• If the firm in question has corporate bonds outstanding, you can use the interest rate on the bond as your pre-tax cost of debt for the firm since it is a current, market-set rate. 
• If a firm has corporate bonds and they are not traded enough or have features that skew the interest rate, you can use the bond rating for the company to estimate a default spread. 
• If the firm has neither bonds nor a rating, a combination that holds for most companies, I would assess a "synthetic rating" for the company, based upon the strength of its financials and its capacity to repay debt.

To bring the tax benefit of debt into the after-tax cost of debt, you should use the marginal tax rate, since interest expenses save you taxes at the margin:

After-tax cost of debt = (Risk free Rate + Default Spread) (1- Marginal Tax Rate)

This cost of debt will be much lower than your cost of equity, for almost all firms.

Debt & Equity Weights

Market or Book? This choice, at least for me, is an easy one. The cost of capital is a measure for what it will cost you to raise money to fund the business, investment or project today, and since you can raise money only at market value, it is the only relevant number. 

Current or Target? This is an argument that often consumes analyst time and often misses the point. It is true that the debt ratio for a company can change over time, and if management does have a target, the actual debt ratio may move to the target. Unless this change is instantaneous, it is likely to occur over time and my answer to the question is to use the current debt ratio to estimate the cost of capital at the start of the investment and as the debt ratio is changed over time to the optimal, to change the cost of capital as well.

Cross Sectional Estimation

In choosing my estimation approach to getting cost of capital, do keep in mind that there are 43,848 firms in my sample and since looking at each one individually is out of the question, I will have to make some bludgeon assumptions (that I would not have made if I were estimating the cost of capital for an individual company). The table below summarizes my estimation choices, with the limitations of each:

	Estimation Approach used	Possible limitations
Risk Free Rate	US T.Bond Rate	Cost of equity estimated in US dollars.
Beta	Started with unlevered beta for sector & levered up using company's D/E (including leases as debt)	Used only the primary business that the company was in. With multi-business companies, I am missing the effect of oither businesses on beta.
ERP	ERP of country that the company is incorporated in.	If company operates in other countries, the ERP should be a weighted average.
Default Spread	Used bond rating, if available, to estimate the default spread. Used interest coverage ratio to estimate ratings and default spread, otherwise.	Interest coverage ratios may not capture default risk fully, Bringing in other ratios might have provided more refined estimate.
Marginal tax rate	Use the statutory tax rate of the country in which the company is incorporated.	If company operates in many countries, it may be able to place its debt in a country with the higher marginal tax rae.
Weights	Current market value of equity and debt (including leases) used for weights.	Insufficient information to estimate market value of interest-bearing debt.

If you want to estimate the cost of capital, using more refined estimates (country weightings for ERP and business mixes for betas), you are welcome to try my cost of capital calculator. If you are working in another currency, converting my estimates of cost of capital to an alternate currency should be a simple exercise of adding the differential inflation rate between the currency in question and the US dollar to my estimate.

The Cost of Capital - Going Concern Concept

There is one important caveat to add about cost of capital specifically and discount rates, in discounted cash flow valuations, more generally. In a discounted cash flow valuation, we are implicitly assuming that the business that we are valuing is a going concern that will either survive for a long time or is on its path to a specified and clearly determined liquidation point.

So what? The reality is that business is risky and the essence of risk is that it can sometime deal out bad enough outcomes to put a company out of business. With a young start up, this may take the form of running out of cash and access to capital. With a declining company, it can be the failure to make a debt payment and the resulting financial distress. With a bank, it can take the form of a drop in regulatory capital below levels acceptable to the regulatory authorities and a shutting down of the bank. With an emerging market company, even a healthy company may see its survival threatened by a nationalization. These are risks that I call truncation risks and analysts often struggle with how best to bring them into value. One path that they try is to push discount rates (or costs of capital) higher for companies that face significant amounts of truncation risk, but discount rates are blunt instruments for dealing with this type of risk and my suggestion is that you not try to adjust them for the risk. Instead, you should consider using a decision tree front on your valuation, where you can bring in your truncation risk concerns separately from your DCF. With a distressed firm or start up, for instance, where you worry about survival risk, the decision tree will look as follows:

This will not only relieve you of the stress of trying to adjust discount rates for risk that they were never meant to convey but will allow you to focus on the truncation risk more directly. Thinking about the probability that you will not survive as a firm and what you will get, if you don't, is a much healthier exercise than arbitrarily pushing up your discount rate another 2%, because you feel the firm is riskier.

The Cost of Capital - Perspective

The cost of capital discussion is permeated with rules of thumb about what comprises reasonable, high or low numbers, many developed in a different time, and for a different market. These rules of thumb skew estimates, since analysts feel the urge to adjust the costs of capitals that they get from models or metrics to match their preconceptions about what they should be. It is my primary objection to the build-up approach for the cost of capital, where analysts add multiple premiums (small cap, illiquidity, company specific) to arrive at a cost of capital that matches what they would have liked to see in the first place. It is to counter this temptation that I will compute costs of capital for US and global companies and present both sector averages as well as the entire distributions for the market. 

US Companies

To provide perspective on what the cost of capital for the median US company will look like, start with the US 10-year T.Bond rate of 2.41% on January 1, 2018, as the risk free rate and my estimate of the implied ERP of 5.08% for the US on the same date. For an average risk stock, with a beta of one, that would translate into a cost of equity of 7.49%. Bringing in the debt ratio of 23.51% for the typical US firm and a pre-tax cost of debt of 3.91% (1.5% higher than the risk free rate), results in a cost of capital of 6.43%, if we use the marginal tax rate of 24%, post tax reform:

Cost of capital for median US firm = (2.41%+5.08%)(1-.2351)+3.91%(1-.24) (.2351) = 6.43%

Using the sector-specific debt ratios and betas yields costs of capital for US companies in individual sectors and the resulting costs of capital are reported in the table below:

Download full sector cost of capital spreadsheet

You can download the spreadsheet with the details of the cost of capital calculation by clicking on the link below. There is information in the company-specific costs of capital estimates that I have for 7.247 US firms in my sample that I try to capture in a histogram:

To the question of what comprises a high, low or average cost of capital, I would offer the deciles for the cost of capital estimation in 2018, also shown in the histogram. 

Global Companies

I estimate the costs of capital for global companies, in US dollars, and using the same template that I use for the US. There are two key differences. The first is that I shift from using the US ERP of 5.08% to a GDP-weighted global average ERP of 6.20%, from a US-average debt ratio of 23.51% to to a global-average debt to capital ratio of 26.67%, from a pre-tax cost of debt of 3.91% to 4.91% (reflecting country default risk) and from a marginal tax rate of 24% to a weighted average of 24.63%. The resulting cost of capital for a median global firm is higher than for the US:

Cost of capital for median global firm = (2.41%+6.20%)(1-.2667)+4.91%(1-.2463) (.2667) = 7.30%

As with the US data, I compute sector averages, using sector average betas and debt ratios and the results are summarized in the picture below:

Download full sector cost of capital spreadsheet

Finally, the distribution of costs of capital across global companies are captured in the histogram, with deciles specified:

Here again, I would use this distribution to make judgments of what a high, low or average cost of capital would look like in January 2018, and adding inflation differentials would provide analogous numbers in other currencies.

The Conclusion

Notwithstanding the length of this post, and the ones leading up to it, I do not believe that the cost of capital is the biggest driver of the value of companies. When you make mistakes in valuation, it is almost always true that the big mistakes are in your cash flow and growth estimates, rather than in your cost of capital. This is especially true when you value young companies, and it is one reason that I am almost casual in my choice of costs of capital in my valuation of Twitter, Uber and Snap, where I have attached costs of capital reflective of the 90th percentile in risk. It is true that as companies mature, the cost of capital becomes a more critical input, but even in these valuations, I would argue that if you are spending more than 20% to 25% of your time estimating it, you have lost your way.

YouTube Video


Paper

1. Cost of Capital - The Swiss Army Knife of Finance\

Datasets

1. Cost of Capital, by Industry Group - US data
2. Cost of Capital, by Industry Group - Global
3. Cost of Capital Calculator (Spreadsheet)

Data Update Posts

1. January 2018 Data Update 1: Numbers don't lie, or do they?
2. January 2018 Data Update 2: The Buoyancy of US Equities!
3. January 2018 Data Update 3: Taxing Questions on Value
4. January 2018 Data Update 4: The Currency Conundrum
5. January 2018 Data Update 5: Country Risk Update
6. January 2018 Data Update 6: A Cost of Capital Primer
7. January 2018 Data Update 7: Growth and Value - Investment Returns
8. January 2018 Data Update 8: Debt and Taxes
9. January 2018 Data Update 9: Dividends, Buybacks and Cash Holdings
10. January 2018 Data Update 10: The Price is Right!

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January 2017 Data Update 6: A Cost of Capital Update!

I have described the cost of capital as the Swiss Army knife of finance, a number that shows up in so many different places in corporate financial and analysis and valuation and in so many different contexts, that it is easy to mangle and misunderstand. In this post, my objective is simple. I will start with a description of the sequence that I use to get to a cost of capital for companies in January 2017, but the bulk of the post will be describing what the cost of capital looks like at the start of 2017 for companies around the world.

The Cost of Capital: Hurdle Rate, Opportunity Cost and Discount Rate
As I move from corporate finance to valuation to investment philosophies, the one number that seems to show up in almost every aspect of analysis is the cost of capital. In corporate finance, it is the hurdle rate that determines whether companies should make new investments, the optimizer for financing mix and the divining rod for how much to return to stockholders in dividends and buybacks. In valuation, it is the discount rate in discounted cash flow valuations and the determinants of enterprise value multiples (of EBITDA and sales).

It is perhaps because it is used in so many different contexts by such varied sub-groups that it remains a vastly misunderstood and misused number. If you are interested in reading more about the cost of capital, you may want to try this paper that I have on the topic (it is not technical or theoretical).

The Cost of Capital Calculation

The cost of capital is the weighted average of the costs of equity and debt for a business. While entire books have been written on the measurement questions, I will keep it simple.

1. The cost of equity is the rate of return that the marginal investors, i.e., the investors who are most influential at setting your market price, are demanding to invest in equity in your business. To get to that number, you need three inputs, a risk free rate to get started, a measure of how risky your equity is, from the perspective of the marginal investors, and a price for taking that risk.

Cost of Equity = Risk Free Risk + Relative Risk Measure * Price of Risk

In the rarefied world of the capital asset pricing model, you assume that the marginal investor is diversified, beta measures relative risk and the equity risk premium is the price of risk, yielding a cost of equity.

2. The cost of debt is the rate at which you can borrow money, long term and today. It is not a historic cost of borrowing, nor can it be influenced by decisions on changing debt maturity. It can be computed by adding a credit or default spread to the risk free rate but it does come, in many markets, with a tax benefit which is captured by netting it out of your cost.

After-tax Cost of Debt = (Risk Free Rate + Default Spread) (1- Marginal Tax Rate)

The default spread can sometimes be observed, if the company issues long term bonds, sometimes easily estimated, if the company has a bond rating and you trust that rating, and sometimes requires more work, if you have to estimate default risk yourself.

3. The weights on debt and equity should be based upon market values, not book values, and can change over time, as your company changes.

Since I want to compute the cost of capital for every one of the 42,668 firms that comprised this year’s sample, I had to make some simplifying (and perhaps even simplistic) assumptions, some of which were necessitated by the size of my sample and some by data limitations. I have summarized them in the picture below.

I have computed the costs of capital for all companies in US dollar terms, not for parochial reasons, since converting to another currency is trivial (as I noted in my post on cracking the currency code) but to allow for consolidation and comparison.

The costs of capital that I compute for individual companies have two shortcomings, driven primarily by data limitations. The first is that the beta that I use for a company comes from the business that it is categorized in, rather than a weighted average of the multiple businesses that it may operate in. The second is that I have attached the equity risk premium of the country of incorporation rather than a weighted average of the ERPs of the countries in which a company operates; I had to do this since the revenue breakdowns by country were either not available for many companies or in too difficult a form to work with. If you want to compute the cost of capital for a company using my data, I have a spreadsheet that you can use that will let you break out of these bounds, allowing you to compute a beta across multiple businesses and an equity risk premium across many countries/regions.

Differences across Geographies

The first comparison I make is in the costs of capital across different countries and regions. The picture below shows cost of capital by country and you can download the data in a spreadsheet at this link.

Link to live map

Given that these are all US-dollar based costs of capital, the differences across countries can be attributed to four factors:

1. Country risk: Country risk shows up in two places in the cost of capital calculation, the equity risk premium for the company (which is set equal to the equity risk premium of the country it is in) and an additional default spread in the cost of debt. 
2. Industry concentration: Since my measure of relative risk comes from looking at the global beta for the sector in which a company operates, the cost of capital for a country will reflect the breakdown of industries in that country. Thus, the cost of capital for Peru, a country with a disproportionately large number of natural resource companies, will reflect the beta of mining and natural resource companies.
3. Marginal tax rate: To the extent that a higher marginal tax rate lowers the after-tax cost of debt, holding all else constant, countries with higher marginal tax rates will have lower after-tax costs of debt and perhaps lower costs of capital.
4. Debt ratio: Twinned with the marginal tax rate, in computing how much a company is being helped by the tax benefit of debt, is the amount of debt that the company uses, with higher debt ratios often translating into lower costs of capital.

Differences across Industry Groups

I next turn to industry groupings and differences in cost of capital across them. In the table below, I list the ten (non-financial service) industry groupings globally, with the highest costs of capital, and the ten, with the lowest, at the start of 2017.

Spreadsheet with all industries

The reason for excluding financial service companies is simple. For banks, insurance companies and investment banks, the only hurdle rate that has relevance is a cost of equity, since debt is more raw material than a source of capital for these firms. You can download the entire industry list (with Global, European, Emerging Market and Australia/Canada worksheets) at this link, but again there are only a few reasons for the differences:

1. Business risk: Some businesses are clearly more risky than others and I am using my sector betas to capture the differences in risk. 
2. Leverage differences: Companies in some sectors borrow more than others, with mixed effects on the cost of capital. The resulting higher debt to equity ratios push up sector betas more, leading to higher costs of equity. That, though, is more than partially offset by the benefit of raising financing at the after-tax cost of debt, a bargain relative to equity.
3. Country exposure: Some industry groupings have geographic concentrations and to the extent that those concentrations are in countries with very low or very high risk, relative to the rest of the world, your cost of capital will be skewed low or high.

Distributional Perspective

I have long argued that analysts spend far too much time on tweaking and finessing costs of capital in valuation and not enough on estimating earnings and cash flows, and I base my argument on a very simple fact. The distribution of costs of capital for publicly traded companies is a tight one, with a large proportion of companies falling in a very narrow range. Rather than talk in abstractions, consider the histogram of costs of capital for US and global companies at the start of 2017:

The median US $ cost of capital for a US company is 7.22%, 50% of all US companies have costs of capital between 5.69% and 8.14%, and 80% have costs of capital between 4.59% and 8.87%. If you expand the distribution to include all global stocks, your distribution widens but not by as much as you might think. The median US $ cost of capital for a global company is 8.03%, half of all global companies have costs of capital between 6.88% and 9.15% and 90% of all companies globally have costs of capital between 5.63% and 10.68%. In other words, you don't have a lot of leeway to move your cost of capital for publicly traded firms. It is true that as you bring in other currencies into the mix, you can make the differences larger, but as I noted in my post on currencies, it is because of differences in inflation. You may want to pay heed to these distributions the next time that you see an analyst using a 20% US$ cost of capital to value a "risky" company or a 3% US$ cost of capital for a "safe" company, since neither number looks defensible, given the distribution.

Cost of Capital Maxims
I think that we not only spend too much time on estimating costs of capital in valuation but we also misunderstand what it is designed to measure. At the risk of repeating myself, here are four suggestions that I have on the cost of capital:

1. Don't make the cost of capital the receptacle of all your hopes and fears: Many analysts take to heart the principle that riskier firms should have higher costs of capital (or discount rates) but then proceed to intuit what that discount rate should be for company, given how risky they think it is.  In the process, they often incorporate risks that don't belong in discount rates and attach prices for those risks that reflect their gut responses rather than what the market is paying.
2. Focus on cash flows, not discount rates: When your valuations go awry, it is almost never because of the mistakes that you made on the discount rate and almost always because of errors in your estimates of cash flows (with growth, margins and reinvestment). 
3. Spend less time on estimating discount rates: It follows then that when you have a limited amount of time that you can spend on a valuation (and who does not?), that time is better spent on assessing cash flows than in fine tuning the discount rate.
4. An approximation works well : When I am in a hurry to value a company, I use my distributional statistics (see graph above) to get started. Thus, if I am valuing an average risk company in US dollars, I will start off using an 8% cost of capital (the global median is 8.03%) and complete my valuation with that number, and if I still have time, I will come back and tweak the cost of capital. If it is very risky firm, I will start off with a 10.68% cost of capital (the 90th percentile) and gain revisit that number, if I have the time.

All in all, if your find yourself obsessing about the minutiae of discount rates in a valuation, it is perhaps because you want to avoid the big questions that make valuation interesting and challenging at the same time.

YouTube Video

Paper on the cost of capital

1. The Cost of Capital: The Swiss Army Knife of Finance

Spreadsheets

1. Cost of Capital Calculator for individual company

Datasets

1. Cost of Capital (US$), by Country - January 2017
2. Cost of Capital (US$), by Industry - January 2017
3. US $ Cost of Capital - Percentiles for US and Global companies

Data 2017 Posts

1. Data Update 1: The Promise and Perils of Big Data
2. Data Update 2: The Resilience of US Equities
3. Data Update 3: Cracking the Currency Code - January 2017
4. Data Update 4: Country Risk and Pricing, January 2017
5. Data Update 5: A Taxing Year Ahead?
6. Data Update 6: The Cost of Capital in January 2017
7. Data Update 7: Profitability, Excess Returns and Corporate Governance- January 2017
8. Data Update 8: The Debt Trade off in January 2017
9. Data Update 9: Dividends and Buybacks in 2017
10. Data Update 10: The Pricing Game

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