Problems with the cost of capital estimation in the current environment

If you're going to value something based on its discounted cash flows, you're going to need a weighted average cost of capital (or an equity cost of capital) to apply to those cash flows. Duff and Phelps recently released a paper discussing the difficulty of determining the cost of capital in today's environment. Some of the problems they address:

Treasury yields (the risk free rate in CAPM) are temporarily low due to liquidity concerns and a flight to quality, understating risk. It is difficult to decompose treasury yields into components of real return, inflation expectations, and reinvestment risk.

The expected equity risk premium (ERP) has increased greatly (as evidenced by the massive decline in stock prices). However, they claim the equity risk premium ranges from 3.5% to 6.0% throughout the business cycle, which seems extremely low to me. We are not in a normal business cycle here, so I think the forward-looking ERP must be higher than 6%.

Declines in financial stocks and companies with high leveraged have outpaced the broader market, leading to a misleading beta calculation that implies risk has actually declined. Beta measures the covariance of a stock's returns with the market's returns. The market had become overweighted with financial stocks that dragged the index down as they declined. So if you compare a non-financial company's stock covariance to the pre-crash market versus its post-crash covariance, it will appear to have decreased, leading to a lower beta. They recommend using a sum beta calculation to correct for this.

Highly levered companies will probably be unable to sustain their debt loads going forward. The cost of capital needs to reflect likely changes to the capital structure over time. Alternately, you could use an approach like adjusted present value (APV) which separates out the value of the tax shields.

Companies operating with substantial losses may not be able to take advantage of the tax shield on interest in the period when it is paid. So the after-tax cost of debt capital may be inappropriate.

Their final recommendation is that any cost of capital calculation must also pass the reasonableness test. Most of these issues stem from the fact that finance theory attempts to use past data to predict future performance. That becomes increasingly hard to justify during times of discontinuous change, such as the one we're experiencing now. For more information, the authors of this paper have published a practitioner's guide to the cost of capital, available at Amazon.