Investment, Q, and the Weighted Average Cost of Capital

Abstract:     
Finance textbooks recommend evaluating investments by calculating the net present value of the free cash flows using the weighted average cost of capital (WACC). In contrast, scholarly studies estimate the impact of Q and cash flow on corporate investment. This paper brings these together by examining the impact of WACC on investment regressions, using 440 alternative implementations of the WACC for US firms from 1960 to 2010. WACC contains significant information not impounded in empirical Q. When the common financial constraint indices are used, WACC has a similar impact on investment for both the constrained and the unconstrained firms. When WACC is decomposed, all elements have effects on investment. The elasticities of investment with respect to leverage and taxation, are larger than the elasticities of investment with respect to Q and cash flow.

Number of Pages in PDF File: 65

Keywords: Investment, Q, WACC, Financial Constraint Index

JEL Classification: G31

working papers series