Cost of Capital: Spot Rate or Forward Rate?

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