Introduction
Following our articles on professional errors in mergers and acquisitions and the breach of duty of care, we now focus on an aspect of valuation techniques that often leads to mistakes: the cost of capital rate. This article discusses the fundamental principles of the cost of capital rate, how it is constructed, and common mistakes made when determining it. Additionally, practical examples and tips are provided to help prevent double counting of risks and ensure accurate valuations.
Introduction to Valuation Techniques
There are several ways to calculate the value of a business, such as the multiple method, liquidation value, and the DCF (Discounted Cash Flow) method. The DCF method is often preferred, combined with a ‘sanity check’ using the multiple method. The cost of capital rate is crucial in the DCF method, which is why we will explore it in more detail.
In the DCF method, enterprise value is calculated by discounting the expected operational cash flows with the cost of capital rate. Subtracting net debt from this value provides the economic value of the shares.
Although this may seem straightforward, errors can occur, especially when determining the cost of capital rate. Such errors can lead to incorrect valuations and advice that may negatively impact the business owner.
What is the Cost of Capital Rate?
The cost of capital rate is the return an investor requires for the expected risk associated with the cash flows of an investment.
Example:
Suppose an investor can invest € 880 today in a financial asset (such as a stock or bond) that will pay out € 1,000 in five years. If the asset carries the same risk as a German government bond—often considered a risk-free investment—the investor would earn 2.6% per year, which corresponds to the current interest rate on a five-year German government bond.
If the investment is riskier, such as a diversified equity portfolio, a market risk premium (MRP) is typically applied. Currently, this premium is around 5%. If the mentioned asset is comparable to such an investment, the investor would be willing to pay only € 693 for the expected € 1,000 payout, which equates to a required return of 7.6% (2.6% + 5%).
In summary
The cost of capital consists of the return required by an investor for the expected risk of the cash flows. For an SME, this required return is composed of the risk-free interest rate, market risk premium, an industry premium/discount, and a company-specific premium.
Where Does It Go Wrong?
Errors often occur when premiums are added to the cost of capital without sufficient justification. For example, additional risk premiums may be included for economic uncertainty or specific business risks such as management, customer, or supplier dependencies. These ad hoc risk premiums can easily lead to either underestimation or overestimation of the existing risk. Furthermore, risk may already be reflected in the expected cash flows, resulting in double counting—once in the cash flows and again in the cost of capital.
Example:
Suppose a company has fluctuating revenues because it sells commodities with highly volatile prices. Instead of accounting for this risk in the cash flow projections, an additional risk premium is added to the cost of capital. However, if an average price for the commodities has already been incorporated into the cash flow forecasts, the risk is counted twice, leading to an undervaluation of the company.
Another example occurs when companies operate in multiple countries and receive payments in different currencies. The valuator must correctly incorporate the risks and inflation associated with foreign currencies into both the cash flow projections and the cost of capital. Inflation expectations and country risk vary significantly between a Dutch company operating in Euros and a Nigerian company operating in Nigerian Naira.
Assessing risks by analyzing potential cash flow losses through various scenarios often provides more insight than adding an ad hoc risk premium. Of course, such assessments are also subject to estimates, such as the probability of cash flow loss and the impact of identified risks. However, unlike an ad hoc risk premium, these estimates can be evaluated and substantiated.
Conclusion
This is just one example of a potential error in determining the cost of capital. It is crucial to exercise due diligence when establishing the cost of capital to avoid double counting risks or overlooking necessary adjustments, such as a country risk premium.