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Three views of deeper and broader skills generate, create data matrix none in .net projects About QR Code Alternative approaches t 2d Data Matrix barcode for .NET o setting the cost of capital It should by now have become apparent that the economic value model, supported by CAPM to set the cost of equity, is far from perfect. This is because, although the theories might sound nice, the practical calculation of an appropriate CoC is highly judgemental.

It is natural therefore that others have tried to propose their own alternative approaches. Some of these approaches involve relatively minor adjustments to how the CoC is assessed while others involve radically different approaches. There is a huge incentive to work in this area.

The prize of a new breakthrough could involve both fame and fortune. Furthermore, research does not require expensive equipment as is the case for scientific discoveries as there are plenty of readily available data with which to test any new hypothesis. It would be highly surprising therefore if there were not a number of competing approaches available.

One of the lessons from history is that we should know our enemy26 and so I will not simply ignore all of the competing theories that are available. Now only a few of the theories are, in my view, objectionable enough to be termed enemies but most are, I believe, distractions and it pays to understand why this is. So to complete this section I will review some of the alternative valuation methods that have been proposed.

These approaches usually start off sounding quite attractive. The problem, however, is usually that when one thinks harder about their application one realises they will add complication to the topic of investment evaluation without giving significantly more accuracy. None of them, as far as I am aware, can get round the problem that we do not know what the future will bring.

The new approaches also suffer from the disadvantage of being relatively untried by senior managers. I will deal first with two radically different approaches. These are the certainty equivalent method and the equity-as-an-option approach.

I should stress at the outset of this venture into academia that I am not an expert in these topics! I have, however, discussed them with some business school professors who are experts and so I am not a complete amateur. The certainty equivalent approach depends on adjusting our future cash flow estimates to cash flows that shareholders would consider to be risk free..

I have read that it was the ancient Chinese warrior Sun Tzu who taught his men to know your enemy before going into battle. His view was that if you know your enemy and know yourself, you need not fear the result of a hundred battles. But, he warned, if you know yourself but not the enemy, for every victory gained you will also suffer a defeat .

. First view: The cost of capital The advantage of this is that these cash flows can then be discounted at the risk-free rate which means that one avoids having to estimate the CoC and one just needs the risk-free rate. My problems with this approach fall into two categories. First, nobody has ever been able to explain to my satisfaction how the transformation from estimated future cash flow to certainty-equivalent cash flow can be done without adopting some of the same type of assumptions which we have to make in our usual valuation approach.

The certainty-equivalent cash flow is not the expected value cash flow. It appears to me that it is defined as the cash flow which an investor would be prepared to discount at the cost of debt. This transformation is tantamount to estimating the additional premium required to remunerate risk which we do when we set the CoC.

My second problem concerns the risk-free rate. Many academics seem to view this as a given. As I have explained above, however, we do not know what the risk-free rate will be in the future, we only ever know what it is today.

Since we are taking long-term decisions we need a long-term estimate of something that is inherently short term in nature. Striving for accuracy in this situation is, I suggest, likely to be pointless. The equity-as-an-option approach involves deconstructing project cash flows into two components.

There are a set of certain cash flows and a set of residual cash flows. These residual cash flows will have many characteristics which make them like options, in particular the fact that they should have limited downside owing to the limited liability nature of equity. Now risk free cash flows can be valued by discounting them at the risk-free rate and options can be valued in a way that will be explained in the next view.

So this offers in theory a radically different way to value projects. My greatest problem with this approach is that it is very much a black box approach. That is to say that one puts numbers into a black box and just has to accept the answer which comes out.

It is very hard to relate the input assumptions to the output value in the way that one can for a typical value calculation. This is because the typical value calculation involves calculating cash flow and this is something which can be measured year by year. A second problem concerns the need to make assumptions about the nature of future volatility.

Options valuations depend crucially on the volatility assumption and on the correlation between different components of cash flow. These assumptions, in my view, can only ever be guesses because we cannot be safe in assuming that past volatilities and past correlations are a good predictor of the future. The equity-as-an-option problem also suffers from the risk-free rate problem.

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