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Cost of Capital: Applications and Examples, 3rd Edition

Author: Shannon P. Pratt, CFA, FASA, MCBA, CM&AA and Roger J. Grabowski
Publisher: John Wiley and Sons
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Description

Cost of capital estimation has long been recognized as one of the most critical elements in business valuation, capital budgeting, feasibility studies, and corporate finance decisions. It is also the most difficult procedure to perform and assess. In this Third Edition, renowned valuation experts and authors Shannon Pratt and Roger Grabowski address the most controversial issues and problems in estimating the cost of capital.

Presenting both the theoretical development of cost of capital estimation and its practical application to valuation, capital budgeting, forecasting of expected investment returns, and rate-setting problems encountered in current practice, Cost of Capital is both a learning text and a handy reference for both the practitioner and the reviewer. Pratt and Grabowski deftly review and explore the theory of what drives the cost of capital, the models currently in use to estimate cost of capital, and the data available as inputs to the models to estimate cost of capital.

Now in a thoroughly updated and comprehensive Third Edition, Cost of Capital summarizes the results and practical implications of the latest research — much of which is gleaned from never-before-published academic working papers—and includes scores of formulas and elucidating examples throughout to enhance readers' insights. Pratt and Grabowski have updated their text to include a host of new material, including:

  • A new chapter covering cost of capital for financial reporting under SFAS 141, 142 and 144
  • A new chapter on risk measures and their relationship to cost of capital
  • Extensive examples illustrating development of cost of equity by the build-up method and the capital asset pricing model using size premiums from Morningstar and the authoritative Duff & Phelps's Risk Premium Report data; development of company-specific risk premiums using Duff & Phelps's Risk Premium Report risk/return data; and development of capital structure at market value and weighted average cost of capital with constant and varying capital structures
  • A new chapter covering cost of capital for companies in developing economies
  • A new chapter covering cost of capital for transfer pricing
  • An update of "Cost of Capital in the Courts"
  • Handling the Discount for Marketability" chapter is now expanded to include sources of data on minority interest transactions and control transactions
  • Specialized chapters by leading experts in real estate, property tax, and family limited partnership valuations

In addition to detailed exposition of the build-up and capital asset pricing models for estimating the cost of capital, Pratt and Grabowski present in-depth analysis of the components, including the equity risk premium, beta and the size effect. The dynamic author team also analyzes criticism of major models for developing estimates of the cost of capital in use today and also present procedures for a number of alternative models. This definitive text is an indispensable reference tool for professional valuation practitioners as well as attorneys and judges, investment bankers, CFOs, academicians and students, and CPAs.

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Table of Contents

  • Part I. Cost of Capital Basics.
    1. Defining Cost of Capital
    2. Introduction to Cost of Capital Applications: Valuation and Project Selection.
    3. Net cash flow: The Preferred Measure of Return.
    4. Discounting versus Capitalizing.
    5. Relationship between Risk and Cost of Capital.
    6. Cost Components of a Company's Capital Structure.
    7. Weighted Average or Overall Cost of Capital.
    8. Appendix 7.1. Iterative Process Using CAPM to Calculate the Cost of Equity component of the Weighted Average Cost of Capital - Constant Capital Structure.
    9. Appendix 7.2. Iterative process using CAPM to calculate the cost of Equity component of the weighted average cost of capital - changing capital structure.
  • Part II. Estimating the Cost of Equity Capital "As If Publicly Traded".
    1. Equity Risk Premium.
    2. 8.1 Appendix.
    3. Build-up models.
    4. Capital Asset Pricing Model (CAPM).
    5. Proper Use of Beta.
    6. Criticisms of CAPM and Beta versus Other Risk Measures.
    7. Size Effect.
    8. Criticisms of Size Effect.
    9. 14.1 Appendix.
    10. D&P Risk Study.
    11. Alternative models to the Build-Up and CAPM models Fama-French, APT, Market derived capital pricing model, Yield-Spread Model.
    12. DCF Method.
    13. Global Cost of Capital models.
    14. Using Morningstar/Ibbotson Associates Cost of Capital Data.
  • Part III. Corporate Financial Officers - Using Cost of Capital Data.
    1. Capital Budgeting and Feasibility Studies.
    2. Cost of capital for divisions/reporting units.
    3. Cost of capital in valuing acquisition/merger.
    4. Cost of capital in transfer pricing.
    5. Cost of capital in Economic Value Added Financial Management System.
  • Part IV. Cost of Capital for Closely-Held Entities.
    1. Handling the Discount for Lack of Marketability For Operating Businesses.
    2. The Private Company Discount.
    3. Pass-through Entities: Partnerships LLCs and S corps.
    4. 27.1 Appendix.
    5. Private Investment Companies.
    6. Venture Capital Investments
  • Part V. Other Topics.
    1. Minority versus Control Implications of the Cost of Capital Data.
    2. How Cost of Capital Relates to Excess Earnings Method.
    3. Adjusting the discount rate to alternative economic Income Measures.
    4. Equivalence With Alternative Cash Flow Methods For Valuing Companies.
    5. Common Errors In Estimation and Use of Cost of Capital.
    6. Cost of Capital In the Courts.
  • Part VI. Real Estate and Ad Valorem.
    1. Cost of Capital For Real Estate Investments.
    2. 36.1 Appendix. Valuing Real Property.
    3. REITs.
    4. 37.1 Appendix.
    5. Cost of capital in Ad Valorem Taxation.
  • Part VII. Advice to Practitioners.
    1. Dealing with Cost of Capital Issues - Advice from the Authors.
    2. Cross Examining Experts On Cost of Capital
    3. Appendices.
    4. Appendix A. Bibliography.
    5. Appendix B. Data Sources.
    6. Appendix C. International Glossary of Business Valuation Terms.
    7. Appendix D. Roger Grabowski's Cost of Capital Section in Kohler Report.
    8. Appendix E. Developing Cost of Capital (Capitalization Rates and Discount Rates) Using ValuSource Valuation Software.
    9. Index.

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816 pages
Hardcover 2008
Product# WI171158
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