Case 13

Teaching Notes

Introduction

“Each year in the US, corporations undertake more than $500 billion in capital spending” (Bruner 184). This case presents a reasonably analyzed set of teaching notes describing how these financially sophisticated corporations estimate their capital costs. Understanding the estimation of capital costs helps identify the uncertainty of the cost-of-capital theory, sets a benchmark for cost-of-capital, helps determine the accuracy of estimating costs, and solves the problem of how a company really estimates their cost of capital.

When dealing with the estimation of capital costs, companies are left to their own discretion on

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With that being said, an arithmetic approach tends to work best for computing the expected returns, while the geometric approach works best for outlaying a historical investment experience. Additionally, neither method is necessarily better than the other, but the arithmetic mean return over T-bills tends to be used more often than the geometric mean. However, both approaches are still focusing on past returns, while the CAPM method calls for forward-looking variables. The differences arise when defining a forward-looking variable that reflects the current market risk premium. Risk Adjustments to WACC Risk is another important factor of the WACC. Only when a company’s WACC can be used as a benchmark for a firm’s average risk investments should a single WACC be used.