You face an important investment decision. To create value for your business, you should only pursue an investment if its returns will exceed the cost of capital invested. Following guidelines from valuation textbooks and business schools, you estimate the cost of equity capital using the standard capital asset pricing model (CAPM). The result is 9%. But wait—do you trust this number simply because CAPM is the standard method? How reliable is it? If you use other methods, would your go/no-go decision change?
Equity is a key source of financing in all companies and almost all projects. Therefore, the method you use to estimate the cost of equity capital is essential for a sound investment decision. The historical advice you received says use the CAPM; however, this advice ignores the concern that CAPM has little empirical support and can lead to uncertain cost of equity capital estimates.
Economists have developed various alternative methods to estimate the cost of equity capital, including:
- Multifactor models such as the Fama-French three-factor model.
- Implied cost of capital (ICC) models such as the Gordon and GLS ICC methods.
- Model-free approaches, including using the historical returns of your company.
These alternatives to using the CAPM have advantages and disadvantages, and the appropriateness of their application depends on the specifics of your company and investment project. For example, these models may require additional parameter estimates, or they may create uncertainty regarding which factors to include. They may provide unreasonably high or low estimates, or vary widely when tied to the stock market. However, when you consider these methods, you can provide a balanced perspective on your company’s cost of equity capital and help to make better investment decisions.
Do you go beyond the CAPM to estimate your cost of equity capital? The Accenture Academy course Using Alternative Methods to Estimate the Cost of Equity Capital explores the available tools to help you determine a more reliable estimate of your company’s cost of equity capital.