Back to Basics: Cost of Capital Depends on Free Cash Flow

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.