The Historic Cost of Capital
by Humphrey Nash

The historic cost of capital is the interest rate used to discount the expected cash flows within the AFTF accounting model.   It emerges from the dual validation procedure.   The discount rate is vital to determining the present values.   If the historic cost of capital is not appropriate then the AFTF model is called into question.   Let's examine some of the characteristics of the historic cost of capital.

Necessary.   If we are dealing with expected cash flows and want to know the shareholder value present in those cash flows we must discount those cash flows to produce a present value.   A discount rate must be chosen or determined.

Unequivocal.   For any particular cash flow model the dual validation determines a unique historic cost of capital.

Easy.   The determination of the historic cost of capital is relatively easy, once the expected cash flows are modeled.

Auditable.  The historic cost of capital is auditable.

Coordinated.   The historic cost of capital is coordinated with the cash flows model.   This is desirable since the historic cost of capital applies to cash flows.

Motivated.   The historic cost of capital is designed to express values using the capital market's scale.

Stable.   The historic cost of capital is reasonably stable.   Since the five-year capital market validation is based on moving five-year procedure it only changes by one fifth of the difference between the new year added and the old year dropped off.
Current.   The historic cost of capital is reasonably current.   It is a five-year trailing development updated each year.
Balanced.  The five-year base period for the historic cost of capital is a reasonable compromise between stability and currency.   This compromise permits the capital markets to communicate the cost of capital while also permitting management to convey its cash flow expectations.   Relevant financial reporting emerges from this dialogue.

Disclosed.  The historic cost of capital is prominently disclosed in the Statement of Values.   The effects of any change in the historic cost of capital are detailed in the Effect of Assumption Changes, Exhibit.2

Comparable.  The historic cost of capital itself can be meaningfully compared from one year to the next or among companies.   Among other things, a lower cost of capital reflects investor confidence in management. More importantly the use of the historic cost of capital makes valuations comparable from year to year and among all companies.   The historic cost of capital scales all value measurements to the capital market value scale.

Superior method.  The dual validation method is superior to other methods for determining the cost of capital.   It is easy and objective.   It accomplishes the goal of expressing value in capital market terms.   Others methods may not achieve this goal, except by coincidence.   Others methods may not be coordinated with expected cash flows.   They may fail simple logical scrutiny.   For example, the CAPM (Capital Asset Pricing Model) derives a cost of capital that is independent of price level of capital!   Other methods may not permit the dialogue between management and the capital markets needed to establish company value.

Decision useful.   Discounting company expected cash flows using the historic cost of capital produces a company valuation that is useful for the shareholder's capital allocation decisions.   This results from the use of a shareholder (capital market) cost of capital.   This same rate of discount is appropriate for use for company internal capital allocation decisions, because management represents the shareholder and must adopt the shareholder's perspective.   The historic cost of capital, as a discount rate, is also useful in pricing decisions, profit studies, managerial performance measurement, etc.

Measures Progress.  The historic cost of capital is not only used as a discount rate for future cash flows, it is the accumulation rate used to bring the prior period end valuation forward to the current time.  Hence value added is defined as the current company value less the prior company value accumulated at the historic cost of capital.

Consistent application.  The historic cost of capital is used for decisions at all levels.   Everybody within an organization will be on the same wavelength -- the shareholder's.   This facilitates decisions and analysis.   For example, separate results can be easily combined.   Manager's will know whether or not their decisions meet the cost of capital.   They will become sensitized to adding value.   They will become sensitized to the future.

Disciplines.   The historic cost of capital disciplines values.   For example, if expected cash flows are exaggerated then the historic cost of capital will increase so that the discounted cash flows are not exaggerated.   This discipline makes the accounting reliable.

Inclusive.  The market cost of capital includes all components needed to discount the future and no more.   It implicitly contains provisions for inflation, a real risk free rate of return, risk of loss of principal, risk of variance in the return (including volatility of share price) and other contingencies not properly factored in to the expected cash flows.   Who says?   The capital market says.   There is no doubling up of discounts since the the historic cost of capital is coordinated with the expected cash flows.

Selectivity.  The historic cost of capital "normalizes" old information (already processed by the capital markets) expressing it in capital market terms, but it allows new information to pass through unaltered so that value added or value lost is clear.

Accepted.  The historic cost of capital is an example of what is called the "intrinsic rate" by accountants. The dual validation is a well defined procedure for determining an intrinsic rate within a disciplined prospective accounting model.

The historic cost of capital serves as a general purpose discount rate.   It is easily determined and unequivocal.   It makes prospective accounting relevant and reliable.   It does the job right and it does the right job.