Estimating cost of equity in project discount rates: comparison of the Capital Asset Pricing Model and Gordon's Wealth Growth Model.
The Southern African Institute of Mining and Metallurgy.
Since the Global Financial Crisis (GFC) in mid-2008, capital has been more difficult to access. Mining projects must contend with projects from other industries for scarce capital. A decision to invest available capital in mineral projects requires that valuation be conducted to assess the expected return on the projects. The discounted cash flow (DCF) analysis is generally applied for the valuation of mining projects, whereby future cash flows are discounted to present value using an appropriate discount rate. The discount rate significantly affects the outcome of a valuation. Economic and finance theory provides tools to calculate discount rates. The discount rate must account for factors such as the risk and stage of development of the mineral project; hence the appropriate discount rate to utilize in a project is often a subject of debate. The discount rate is the weighted sum of the cost of debt and equity. There are several methods for determining the cost of equity. This study considers the commonly applied Capital Asset Pricing Model (CAPM) and Gordon's Wealth Growth Model because of their simplicity and availability of parameters required to estimate the cost of equity. This study explores how differences in the cost of equity obtained by these two methods can be explained for a mining environment. Data for empirical analysis were collected from the I-Net Bridge, McGregor BFA, and Bloomberg databases. It was found that Gordon's Wealth Growth Model provides better estimates of the cost of equity compared to the CAPM under depressed market conditions. Therefore, this research recommends that Gordon's Wealth Growth Model be used to estimate the discount rates for mining projects during periods of depressed market conditions.
This paper refers to part of a MSc research study undertaken at the University of the Witwatersrand.
Capital Asset Pricing Model , Cost of equity , Discount rate , Gordon's Wealth Growth Model , Mining projects , Cost benefit analysis , Empirical analysis
Nhleko, A. S. and Musingwini, C. 2016. Estimating cost of equity in project discount rates: Comparison of the Capital Asset Pricing Model and Gordon's Wealth Growth Model. Journal of the Southern African Institute of Mining and Metallurgy. 116(3), pp. 215-220. DOI: 10.17159/2411-9717/2016/v116n3a1