Companies Lack Confidence in own Cost of Capital Calculations

The methods that financial professionals typically use to assess the future performance of their organisation’s strategic investments are critical to future success, says the Association for Financial Professionals (AFP) in its new report, entitled ‘Current Trends in Estimating and Applying the Cost of Capital’.

The report enables companies to compare techniques against those of their peers and is based on a 35-question survey that the AFP issued in July to senior level corporate practitioner members and prospects with job titles including chief financial officer (CFO), treasurer and director of finance.

The survey generated 424 responses from both public and private organisations spanning a wide range of industries, with the largest concentration in the manufacturing industry.

“Decisions about strategic investments can define the future of the company. Yet very few companies are confident that their cost of capital estimates are accurate,” said Jim Kaitz, AFP’s president and chief executive officer (CEO). “We believe that achieving standards in financial planning and analysis for professional staff, and understanding the tools and practices that successful companies use will be critical to corporate decision making in the future.”

The report, part of AFP’s ongoing benchmarking and standard-setting in the field of corporate financial planning and analysis, updates a comprehensive study originally launched in 2010.

Among the findings in the 2013 report:

• Small fluctuations in cost of capital can create huge swings in discounted cash flow figures strongly affecting strategic decisions about future capital investments and acquisitions.
• A majority of organisations continue to use the capital asset pricing model (CAPM) for estimating their cost of equity, with considerable variance in how they apply the model.
• For estimating a risk-free rate, most organisations adopt a long-term view and use instruments with maturities of five years and longer. Since AFP’s original 2010 study and following the Standard & Poor’s (S&P) downgrade of US sovereign debt during the summer of 2011, however, more companies are using short-term instruments.
• Compared to 2010, more organisations are imposing a cap or floor on the risk-free rate used to evaluate projects and investment, reflecting a riskier environment today.
• Only two of five organisations that use current or target market values to calculate weight for weighted average cost of capital (WACC) analysis use current or forward looking measures. The rest use historical weights or book values.
• Only 22% of financial planning and analysis FP&A professionals believe that their cost of capital estimates accurately reflect the actual cost of capital, or that the estimate is within 25 basis points of the actual cost of capital.

The report can be downloaded here.

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