When executives evaluate a potential investment, whether it’s to build a new plant, enter a new market, or acquire a company, they weigh its cost against the future cash flows they expect will spring from it. To make sure they’re comparing apples to apples, they discount those future cash flows to arrive at their net present value. Estimating the rate at which to discount the cash flows—the cost of equity capital—is an integral part of the exercise, and the choice of rate has a significant effect on estimates of a project’s or a company’s value. For instance, if you had recently run a discounted cash flow, or DCF, valuation on the UK-based mobile phone giant Vodafone, you would have found that changing the discount rate from 12% to 11.6%—hardly a major change—would have increased the company’s estimated value by 15%, or £13.4 billion.
What’s Your Real Cost of Capital?
The traditional approach to evaluating capital investments has a fatal flaw. Here’s how to get numbers you can count on.
A version of this article appeared in the October 2002 issue of Harvard Business Review.
New!
HBR Learning
Budgeting Course
Accelerate your career with Harvard ManageMentor®. HBR Learning’s online leadership training helps you hone your skills with courses like Budgeting. Earn badges to share on LinkedIn and your resume. Access more than 40 courses trusted by Fortune 500 companies.
Tips, tools, and info for handling the budgeting process.
Learn More & See All Courses
New!
HBR Learning
Budgeting Course
Accelerate your career with Harvard ManageMentor®. HBR Learning’s online leadership training helps you hone your skills with courses like Budgeting. Earn badges to share on LinkedIn and your resume. Access more than 40 courses trusted by Fortune 500 companies.
Tips, tools, and info for handling the budgeting process.