Flaws and Errors in the Rules of Thumb Cost of Capital

When using rules of thumb to figure the cost of capital, you have to know that there are certain flaws and errors in rules of thumb that can cost an owner or valuation user large losses and errors. Rules of Thumb formulas are estimations and do not take into account the specific company situations or the specific market conditions. The market conditions change continually and need to be specifically considered. Any number of things can cause the market to change. Economic factors fluctuate daily. Specific business conditions are important facts that influence the cost of capital. Other less frequent situations can also influence the cost of capital such as natural disasters, government policy at home or in other nations, sudden wars, and other politically driven challenges that can alter numbers.

Every investment or cost of capital need must consider all of the risk elements. These include 1) the Risk-Free rate, 2) Equity vs. Debt rate, 3) Size rate, 4) Industry rate, and 5) Specific Company rate.  Economic conditions may also need to be considered. If you only work with Rules of Thumb then all of the specific conditions will not be considered and large errors can occur.

Perhaps the most difficult part of the flaws and errors in the rules of thumb cost of capital is the fact that their use often leads to decisions that can significantly impact the business and lead to detrimental consequences.  Valuation professionals understand the true nature of the risk and develop accurate Cost of Capital numbers that increase the accuracy and correct use that leads to proper valuation calculations. Always use a professional to calculate the proper cost of capital.