Return to Basics: Cost of Capital Depends on Free Cash Flow
The IUP Journal of Applied Finance, Vol. 16, No. 1, pp. 27-39, January 2010
17 Pages Posted: 12 Oct 2008 Last revised: 25 Jan 2016
Date Written: January 22, 2016
Most popular corporate finance textbooks (See Benninga and Sarig, 1997, 2007 Brealey, Myers and Marcus, 1996, Brealey, Myers and Allen, 2006, Brealey and Myers, 2000, 2003 and previous editions, Copeland, Koller and Murrin, 1995 and 2000, Damodaran, 1996, Gallagher and Andrew, 2000, Van Horne, 1998, Weston and Copeland, 1992) and practitioners (see World Bank, 2002) present the Weighted Average Cost of Capital WACC calculation as independent from the Free Cash Flow.
It is a common use that practitioners calculate a WACC a priori and use it independently from the firm value (this is, from FCF). In this teaching note we show that FCF affects WACC and that this interrelationship creates circularity, but it can be solved in a very easy way.
There are two appendixes: one explaining the circularity issue and another one for deriving the proper formulation of the cost of equity.
Keywords: Weighted Average Cost of Capital, WACC, firm valuation, capital budgeting, equity cost of capital, circularity
JEL Classification: D61, G31, H43
Suggested Citation: Suggested Citation