Cost of Capital: Spot Rate or Forward Rate?

21 Pages Posted: 28 Jul 2015

See all articles by Howard Qi

Howard Qi

Michigan Technological University; Independent

Yan Alice Xie

University of Michigan at Dearborn

Date Written: July 15, 2015

Abstract

In this study, we intend to reveal some problems with the classic valuation method - the Weighted Average Cost of Capital (WACC) method. We first address a fundamental question about WACC, i.e. should WACC be interpreted as a spot rate, a forward rate, or any kind of average of either of them? We show that the nature of WACC is the expected forward rate. We next demonstrate that without understanding this nature, we may misinterpret the famous MM formula and MM Proposition II, as well as develop incorrect valuation framework. Our findings provide insightful implications to academia and practitioners for the proper interpretation and implementation of the WACC method.

Keywords: capital structure, WACC, CCF, APV, spot rate, forward rate

JEL Classification: G31, G32

Suggested Citation

Qi, Howard and Xie, Yan, Cost of Capital: Spot Rate or Forward Rate? (July 15, 2015). Available at SSRN: https://ssrn.com/abstract=2635739 or http://dx.doi.org/10.2139/ssrn.2635739

Howard Qi

Michigan Technological University ( email )

1400 Townsend Dr.
Houghton, MI 49931
United States

Independent ( email )

Yan Xie (Contact Author)

University of Michigan at Dearborn ( email )

Dearborn, MI
United States

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