Back 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

Posted: 12 Jan 2010

See all articles by Ignacio Velez-Pareja

Ignacio Velez-Pareja

Grupo Consultor CAV Capital Advisory & Valuation

Date Written: January 6, 2010

Abstract

Most popular corporate finance literature and practitioners present the Weighted Average Cost of Capital (WACC) calculation as independent from the Free Cash Flow (FCF). It is a common practice that practitioners calculate a WACC a priori and use it independently from the firm value (i.e., from FCF). This study shows that FCF affects WACC and that this interrelationship creates circularity, and also how the same can be solved in a very easy way. The two Appendixes of the paper explain the circularity issue and deriving a proper formulation of the cost of equity.

Suggested Citation

Velez-Pareja, Ignacio, Back to Basics: Cost of Capital Depends on Free Cash Flow (January 6, 2010). The IUP Journal of Applied Finance, Vol. 16, No. 1, pp. 27-39, January 2010. Available at SSRN: https://ssrn.com/abstract=1532066

Ignacio Velez-Pareja (Contact Author)

Grupo Consultor CAV Capital Advisory & Valuation ( email )

Ave Miramar # 18-93 Apt 6A
Cartagena
Colombia
+573112333074 (Phone)

HOME PAGE: http://cashflow88.com/decisiones/decisiones.html

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