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Foreword
Many of us have been anxiously awaiting Shannon Pratt’s second edition of Cost
of Capital: Estimation and Applications, following the successful first edition. The
current edition includes a totally rewritten and expanded chapter on how to use Ibbotson
Associates’ new Stocks, Bonds, Bills, and Inflation® Valuation Edition Yearbook,
emphasizing the easy-to-use build-up method, as well as providing clarifying links to
many of our other methods and products throughout this book. Shannon also has
added a chapter on the cost of capital in Economic Value Added (EVA)®, included
new sections and data on lack of marketability, control, and minority interests, and
provided results from new studies on micro-stocks, sold companies, and price valuation
multiples.
Shannon Pratt has been a leader in the valuation field for decades, writing numerous
books, operating a consulting and valuation firm, and producing such industry
resources as Shannon Pratt’s Business Valuation Update® and Pratt’s Stats™. He
has been a collector and provider of data and information on prices, ratios, deals, and
sales, as well as legal and tax developments in the industry. He has been a developer
and compiler of theoretical approaches and practical procedures. It is particularly
helpful that he has turned his attention to the cost of capital.
The cost of capital is a critical component of both the valuation and the corporate
decision-making processes. Yet the theory is much less understood than the theory
of forecasting expected cash flows. For example, increasing leverage may increase
the cost of equity and the cost of debt without necessarily affecting the weighted average
cost of capital. Cost of capital procedures are a frequent source of major logical
errors, not just judgment errors. Mistakes of this type can leave the decision
maker or appraiser vulnerable, inasmuch as he or she can actually be proven wrong.
This is an area where practitioners badly need a guide such as Cost of Capital, so they
understand what they are doing.
The cost of capital is one of the key components in valuation. But it is rarely observed
directly. Instead, it must be estimated. Numerous models can be used to estimate
the cost of capital, such as the build-up models, the Capital Asset Pricing Model, the
discounted cash flow model, and the arbitrage pricing theory. These models may require
adjustments for risk, capital structure, size of company, and so forth. There are
also many ways to estimate the parameters in these models. All of them may be combined
in the weighted average cost of capital. Ibbotson Associates is the provider of
many of these estimates. I certainly welcome the second edition of Cost of Capital as a
publication that can help to educate practitioners about what the data mean and how
they can use them.
This book is beginning to serve as the standard reference on cost of capital. It will
join Shannon Pratt’s set of valuation books in providing the theoretical foundations
and practical procedures in valuation, capital budgeting, and investment decision making.
However, cost of capital is the most challenging subject in valuation, with the
richest data and most complex issues. I am personally enthusiastic about adding this
book to my reference library.
Roger G. Ibbotson
Chairman, Ibbotson Associates
Professor in Practice, Yale School of Management
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