Applying the empirical average cost of capital: Estimating the cost of funds at the firm and industry levels

Abstract

ABSTRACT This article 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 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. We find the EACC yields forecasts of future net operating profit after taxes that compare favourably to five published measures of the weighted average cost of capital and is robust to several alternative tests. 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.