Applying the Empirical Average Cost of Capital: Estimating the Cost of Funds at the Firm and Industry Levels

48 Pages Posted: 23 Mar 2017 Last revised: 24 Sep 2018

See all articles by Gerard T. Olson

Gerard T. Olson

Villanova University - School of Business

Michael S. Pagano

Villanova University - Villanova School of Business

Date Written: September 13, 2018

Abstract

This paper develops a new measure of the cost of capital, the empirical average cost of capital (EACC), which is consistent with existing methods of calculating the weighted average cost of capital but primarily uses information from the firm’s financial statements and requires fewer and less subjective inputs. Our model combines the regression-based approach of asset pricing models such as the CAPM with the implied cost of capital’s reliance on accounting and market price data. The EACC model is very flexible and can identify the optimal balance between accounting- and market-based data that should be used when estimating the cost of capital for individual firms as well as for industries and larger economic sectors. In addition, the model can be estimated using either time series, cross-sectional, or panel data sets. Estimates of the EACC for 58 U.S. industries are compared to five conventional “textbook” estimates of the weighted average cost of capital currently published by Duff & Phelps. We find the EACC yields forecasts of future net operating profit after taxes that compare favorably to the five published measures of the weighted average cost of capital, as well as the average and median of these measures. The method is also useful to construct cross-sectional and panel-based cost of capital estimates. Overall, the results suggest the EACC can be an effective complementary method for corporate managers, investors, financial analysts, accountants, regulators, and academics in deriving estimates of a company’s or industry’s cost of capital.

Keywords: Cost of Capital, Empirical, Capital Budgeting, Corporate Finance

JEL Classification: G32, G31, G3

Suggested Citation

Olson, Gerard T. and Pagano, Michael S., Applying the Empirical Average Cost of Capital: Estimating the Cost of Funds at the Firm and Industry Levels (September 13, 2018). Available at SSRN: https://ssrn.com/abstract=2939196 or http://dx.doi.org/10.2139/ssrn.2939196

Gerard T. Olson

Villanova University - School of Business ( email )

800 Lancaster Avenue
Villanova, PA 19085-1678
United States
610-519-4377 (Phone)

Michael S. Pagano (Contact Author)

Villanova University - Villanova School of Business ( email )

800 Lancaster Avenue
Villanova, PA 19085-1678
United States
(610) 519-4389 (Phone)

HOME PAGE: http://www90.homepage.villanova.edu/michael.pagano

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