The Relation Between the Cost of Capital and Economic Profit

Abstract

This paper develops a new measure of the cost of capital, the empirical average cost of capital (EACC), which is based on microeconomic theory and uses information from the firm’s financial statements as opposed to the subjective estimates and use of market-based proxies inherent in the calculation of the weighted average cost of capital. Our model combines the regression-based approach of the Capital Asset Pricing Model (CAPM) with the implied cost of capital’s reliance on accounting data. The EACC can be estimated using firm level as well as industry data. Estimates of the EACC for 58 U.S. industries during the 1990 to 2012 period are compared to five estimates of the weighted average cost of capital published by Ibbotson Associates. We find the EACC yields better forecasts of future net operating profit after taxes compared to the five published measures of the weighted average cost of capital, as well as the average and median of these measures. Overall, the results suggest the EACC can be a more precise and less subjective measure for academics, accountants, financial analysts, and regulators in deriving estimates of an industry (or firm’s) average cost of capital.