Computer, Computer, on the Wall, Which Cost of Capital is Fairest, of Them All?

Abstract

For the practitioner, making sense of the bewildering number of theories on the cost of capital must be a truly challenging and daunting task. In a perfect world without taxes, the cost of capital formula for a finite stream of free cash flows, with debt and equity financing, is elegant, simple and eminently sensible. The cost of capital is a weighted average of the cost of debt and the cost of equity, where the weights are the market values of debt and equity as percentages of the levered market value. In a perfect world with taxes, complications abound.

What criteria should we use to select the best expression for the cost of capital from all the available formulations? Fundamentally, the cost of capital is a question about how to properly account for the tax benefits (if any) from the interest deduction with debt financing. In other words, what are the appropriate risk-adjusted discount rates for the tax shield? At last count, there were 23 theories!

In this note, we briefly describe two methods for estimating the cost of capital: the traditional after-tax WACC applied to the free cash flow (FCF) and the alternative WACC applied to the capital cash flow (CCF). Using three criteria, simplicity, flexibility and correctness, we assess the strengths and weaknesses of the two different methods for calculating the cost of capital. Based on these criteria, we select the best expression for the cost of capital for a finite stream of cash flows.

Keywords: WACC; Cost of capital; Free cash flow (FCF); Capital cash flow (CCF); Cash flow to equity (CFE)

JEL Classification: D61, G31, H43