Document Detail

What's your real cost of capital?
MedLine Citation:
PMID:  12389465     Owner:  NLM     Status:  MEDLINE    
In valuing any investment project or corporate acquisition, executives must decide what discount rate to use in their estimates of future cash flows. The traditional approach is to apply the capital asset pricing model (CAPM), which has remained fundamentally unchanged for 40 years. But the formula--in particular, its beta element--has long been a source of frustration. In fact, corporate executives and investment bankers routinely fudge their CAPM estimates, say the authors, because experience and intuition tell them the model produces inappropriate discount rates. CAPM has three main problems: First, beta is a measure of both a stock's correlation and its volatility; second, beta is based on historical data; and third, CAPM rates don't take into account the term of the investment. These factors together result in discount rates that defy common sense. As an alternative to CAPM and its beta element, the authors developed a forward-looking approach to calculating a company's cost of capital, the market-derived capital pricing model (MCPM). It does not incorporate any measure of historical stock-to-market correlation, relying instead on estimates of future volatility derived from the options market. This is helpful since investor expectations from the options market are built into a company's current stock price. Using GE as an example, the authors give step-by-step instructions for how to calculate discount rates with MCPM. They also offer evidence from a range of industries to show that MCPM's discount rates are more realistic--especially from the corporate investor's perspective--than are CAPM's.
James J McNulty; Tony D Yeh; William S Schulze; Michael H Lubatkin
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Publication Detail:
Type:  Journal Article    
Journal Detail:
Title:  Harvard business review     Volume:  80     ISSN:  0017-8012     ISO Abbreviation:  Harv Bus Rev     Publication Date:  2002 Oct 
Date Detail:
Created Date:  2002-10-22     Completed Date:  2002-12-24     Revised Date:  2004-11-17    
Medline Journal Info:
Nlm Unique ID:  9875796     Medline TA:  Harv Bus Rev     Country:  United States    
Other Details:
Languages:  eng     Pagination:  114-21, 130     Citation Subset:  H    
Chicago Mercantile Exchange Incorporated, USA.
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MeSH Terms
Accounting / methods*
Capital Expenditures / statistics & numerical data*
Capital Financing / statistics & numerical data*
Commerce / economics*
Cost Allocation / methods
Decision Making, Organizational
Investments / economics*
Models, Econometric
United States

From MEDLINE®/PubMed®, a database of the U.S. National Library of Medicine

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