A novel approach to calculate weighted average cost of capital (WACC) considering debt and firm's cash flow durations

Abstract

AbstractThis paper presents a novel approach to calculate the weighted average cost of capital (WACC) but considering additional relevant variables to be applied to a specific cash flow, free cash flow to firm (FCFF), or capital cash flow (CCF), in order to value an asset. The analytical expressions deduced for this approach, one for each case, are based not only on the ratio debt to the value of the asset and the cost of debt and equity, as in the usual expression, but also includes the debt and firm's cash flow durations. The proposed novel approach to cost of capital has key advantages in comparison to the usual expression for WACC: It is an analytical expression that could be applied to whatever kind of debt or capital structure, not only perpetual debt or permanent capital structure. It is a single discount rate, and for its calculation, it is not necessary to recalculate financial factors involved, which makes easier its application. The additional financial variables involved, debt and firm's cash flow duration, allow to obtain better results for the right discount rate and for the value of an asset in the sense that the discount rate for the asset effectively will permit to reach the required level for the profitability for the investor and to cover the cost of debt.