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This chapter reviews the findings of academic surveys of corporate executives indicating the estimation and use of cost of capital (also known as weighted average cost of capital or WACC). The chapter compares the survey findings to the theoretically correct methods and applications described and recommended in the academic literature. The chapter goals are to identify past trends, ascertain current practices, and evaluate the existing gap between theory and practice. Major areas of investigation include the weighting schemes used to estimate the cost of capital and how firms arrive at their cost of debt and cost of equity estimates. Other areas include the use of multiple hurdle rates, the frequency of WACC calculation, numerical values of WACC, selecting the values of Capital Asset Pricing Model (CAPM) variables, using divisional betas, recognizing a slope in the marginal cost of capital line, applications of the cost of capital, and the effect of firm disclosure on the cost of capital. While most studies discussed here focus on large U.S. firms, many focus on non-U.S. firms, multinational firms, multi-division firms and small firms.

This chapter shows how the firm should design sales force compensation plans to maximize its performance. It distinguishes whether or not the firm can observe the salesperson's effort. It shows how marketing-finance fusion allows the firm to design compensation plans based on such factors as the firm's cost structure, cost and demand uncertainty, consumer satisfaction, the firm's cost of capital, and whether or not the firm delegates price-setting or sales call policy to the salesperson. It shows how the sales force compensation plan should allow for multiperiod effects and the impact of Internet advertising. In particular, it distinguishes different scenarios (e.g., whether Internet advertising and conventional advertising are substitutes or complements).

Economic value added (EVA) is based on the concept of residual income. For the financial accountant, there is no cost for equity capital. However, for the financial economist, a cost is associated with the use of equity capital—the opportunity cost of these funds. After considering this cost, we have the residual income. Still, EVA is more than residual income; it is also intended to eliminate the “distortions” created by the financial accountant that make no economic sense. The primary purpose of EVA is to provide an answer to the question, is management creating value for its shareholders? However, to think that EVA is simply about calculating a number—as informative as that might be—would miss an important point. In short, the intent is to use EVA as a behavioral tool to alter capital utilization and other incentives rather than as a tool of financial analysis.

Financial theory predicts that multinational corporations (MNCs) should have a lower cost of capital and a higher leverage level compared to domestic corporations (DCs) because of their enhanced access to global capital markets and risk diversification across countries. Empirical evidence, however, shows that the answer depends on the MNCs' home and host country factors, such as capital market development, institutional environment, and political stability. While the prediction holds for MNCs based in emerging markets, the opposite is observed for U.S. MNCs that expand into less stable economies. The increased globalization of the product and capital markets in the 1990s has also narrowed the gap in cost of capital between MNCs and DCs and this trend is likely to continue in the future.

This chapter begins by describing the application, usefulness, and limitations of normative and positive theory. The chapter continues with a discussion of the application, usefulness, and limitations of empirical research using both direct and indirect data, and survey research which uses only direct data. The discussion provides strong support for the usefulness of survey research. The chapter proceeds to review the major findings of survey research discussed in the earlier chapters on capital budgeting, cost of capital, capital structure and financing decisions, dividends and dividend policy, share repurchases (also special dividends, stock splits, and stock dividends), and risk management and derivatives.

The concept of free cash flow is the foundation of value-based management. No matter what we choose to do, free cash flow should be at the heart of any effort to understand how management can contribute to a company's value. It is equal to the cash flow from operations less any incremental investments in working capital and capital expenditures. However, what makes free cash flow important is that it represents the amount distributed to a firm's investors and, as such, represents the core determinant of the company's value. The determinants of value, or what are called “value drivers,” include sales, sales growth, operating profit margins, asset-to-sales relationships, and cash taxes. Management should be committed to strategies that create value, that is, to strategies in which the present value of the growth opportunities is positive.

This chapter first explains the importance of using a single metric to manage the creation of a firm's value. While multiple-measure techniques such as the balanced scorecard can yield valuable information, they fail to provide managers with a means to make necessary tradeoffs. The question then becomes, what metric best measures value creation? The chapter discusses several shortcomings of traditional metrics, both market based (e.g., shareholder return) and accounting based (e.g., net income and return on invested capital). These deficiencies center around the failure of traditional metrics to provide any charge of nondebt financing, therefore leading to a faulty appearance of profitability. Economic profit metrics avoid these pitfalls because they incorporate the magnitude of both the return and the required investment, as well as the opportunity cost of capital. The decision rule becomes simple: Fund projects with expected positive economic profit, and reject the others.

In this chapter, we discuss the financing costs associated with working capital. Given that working capital is financed with both long‐term debt and equity, we identify the corresponding risk associated with each type of contract and explain that the compensation to investors should be different according to the type and size of the underlying risk. After determining the costs associated with these sources of funds, we combine these costs using the concept of weighted average cost of capital.

The market risk premium (MRP) remains one of the most debated issues in corporate finance. The MRP is a critical input when measuring a company’s cost of equity and weighted cost of capital. Thus, a company’s estimate of the MRP can have major effects on its capital budgeting decisions. This is especially true when estimating the MRP in emerging markets, where expected returns are widely understood to be affected by variables other than those specified by the capital asset pricing model (CAPM). The purpose of this chapter is to investigate the degree of integration or lack thereof (segmentation) between capital markets and to develop a modified CAPM for financial decision-making in emerging markets.

This chapter discusses how the use of public-private partnerships (PPPs) to provide critical infrastructure is rising in the United States. One of the main arguments in favor of public provision, however, is that the public sector enjoys a lower social cost of capital relative to the private sector. This view is false. The legal and organizational arrangements surrounding private investor risk bearing results in a lower private-sector cost of capital. The inability of taxpayers, as risk bearers of public investment, to exit implies that they are obligated to provide uncompensated risk-bearing services. Unpriced taxpayer risk bearing artificially lowers the public sector's cost of capital. This raises important competition issues. To ensure competitive neutrality—so government-bestowed benefits do not result in unfair competition—the cost of taxpayer-provided risk-bearing services should be included in comparisons of public versus private infrastructure provision.

This chapter describes the IGEM in detail – the demand and supply sides of the economy, the inter-industry (input-output) structure and the determination of intertemporal equilibrium. The production function allows for substitution among inputs, autonomous technical change, and induced technical change. The household model allows an aggregate demand function to be expressed as a sum of individual household demand functions; this aggregate function is non-homothetic and depends on the demographic projections of the population. Household optimization also generates goods demand and labor supply. Intertemporal optimization generates savings and hence investment for capital accumulation and the cost-of-capital equation. The model is made consistent with the National Accounts and the Input-Output accounts. We describe the solution algorithm.

This chapter analyzes the advantages and disadvantages of capital flows for the international financial market. It explains the benefits of capital mobility which include reduction of the cost of capital, improvement in corporate governance and differentiation of a country's capital from its investments. This chapter considers the issue of whether the costs of sudden withdrawals of capital by foreign investors can offset the benefits of capital mobility. It also argues that the appropriate policies to eliminate the fragility of emerging economies are policies that foster better financial structures, so that long-term contracting can be supported.

This chapter sets out the origins of RPI-X regulation and the context of privatization, with its multiple objectives—and not just efficiency. It describes the salient framework of the regulatory institutions and, in particular, the considerable scope for ex post intervention created by the widely drawn general duties of the regulators, and then turns to the financial dimensions of regulation and the regulatory asset bases (RABs) and the determination of the cost of capital. Having set out the main architecture of RPI-X, the chapter turns to the two examples of ex post intervention—the revision of price caps within periods and the windfall tax. The chapter then sets out the main implications that flow from these examples, and provides a framework for more efficient ex ante contracts that might mitigate the scope for ex post interventions. Before concluding, the chapter briefly contrasts the experience in the utilities with that of the North Sea oil and gas development.

After a short literature review on the cost of capital for private equity (PE), this chapter focuses on the cost of equity estimation for PE. First, unbiased estimators are used to correct for econometric bias induced by errors-in-variables in linear asset pricing models. Second, an adjustment method is used to deal with the problem of stale valuation and illiquidity observed in the PE industry. Third, with these valuation improvements, the chapter provides new evidence on the importance of the liquidity premium on PE returns. The results show that risk factors related to the market premium, size effect, book-to-market effect, and liquidity premium may be useful in computing the cost of capital of PE. Adjusted multifactor models should be considered in the process of PE valuation with special attention and adaptation for the different classes of PE.

Private equity (PE) firms generate returns by following an investment process similar to that of any investor. That is, they buy assets at a price for less than what they can be sold in the future. Sound valuation analysis is a key part of this process. PE firms must employ methods that reflect the current value of target companies as well as the potential value of these companies after realizing expected operating and financing improvements. This chapter presents a detailed discussion of the key issues involved in a valuation analysis and provides a comprehensive numerical example. Topics covered include measures of cash flow, using cash flow to estimate value, discounted cash flows (DCF), adjusted present value (APV), and multiples valuation methods, as well as estimating the cost of capital for PE valuation.

The author focuses in this chapter on the workhorse income approach to valuation. Based on his extensive practical experience, he discusses the essential steps of forecasting future business revenue, identifying income arising from that revenue, and discounting that future income for time and risk. The author argues that, while each of these tasks are important, forecasting business revenue is often the most important.