A Note on Corporate Valuation Using Imprecise Cost of Capital

55 Pages Posted: 8 Sep 2015 Last revised: 10 Jun 2016

See all articles by Wolfgang Breuer

Wolfgang Breuer

RWTH Aachen University

Karsten Kohn

Kreditanstalt für Wiederaufbau (KfW), KfW Development Bank; IZA Institute of Labor Economics

Klaus Mark

Kreditanstalt für Wiederaufbau (KFW)

Date Written: June 08, 2016

Abstract

We compare the estimator for discount rates according to Elsner and Krumholz (EK) (2013) to the approach propagated in Breuer et al. (2014) (BFM). While the EK estimator is derived analytically and implies a correcting factor by which the original arithmetic mean estimator is adjusted, the BFM approach is based on a simple ad hoc modification and recommends to truncate the time horizon for cash flow projection up to about N = 30 years. The BFM approach is reasonable, as the most relevant bias problems are implied by terminal value computations. Rather surprisingly, for our main simulation analysis based on real-world capital market data for 19 countries over the period 2008-2012, the EK estimator turns out inferior to the BFM approach. However, results depend on the kind of bias measure and on the issue of whether using total historical returns or only excess returns for evaluation purposes. In any case, our findings imply that a rather straightforward rule of thumb for valuation may be of value to practitioners: ‘stick to the simple arithmetic mean estimator without terminal value computation, but consider future cash flows up to a time horizon of about 30 years’.

Keywords: arithmetic mean, cost of capital, estimation bias, firm valuation, geometric mean

JEL Classification: G12, G34, G24

Suggested Citation

Breuer, Wolfgang and Kohn, Karsten and Mark, Klaus, A Note on Corporate Valuation Using Imprecise Cost of Capital (June 08, 2016). Available at SSRN: https://ssrn.com/abstract=2657025 or http://dx.doi.org/10.2139/ssrn.2657025

Wolfgang Breuer (Contact Author)

RWTH Aachen University ( email )

Templergraben 55
D-52056 Aachen, 52056
Germany

Karsten Kohn

Kreditanstalt für Wiederaufbau (KfW), KfW Development Bank ( email )

Palmengartenstr. 5-9
Frankfurt, 60325
Germany

IZA Institute of Labor Economics ( email )

P.O. Box 7240
Bonn, D-53072
Germany

Klaus Mark

Kreditanstalt für Wiederaufbau (KFW) ( email )

Palmengartenstrasse 5-9
60325 Frankfurt am Main
Germany

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