A look at the actual cost of capital of US firms

Abstract

The capital asset pricing model (CAPM) receives both criticism and widespread adoption by practitioners and academics as the weighted average cost of capital (WACC) equity component. This study introduces two new costs of equity measures to address CAPM criticisms and provide new perspective on WACC estimates. The firm-based measure focuses on firm–investor cash flows while the market-based measure focuses solely on actual market returns. This study applies its firm and market-based WACC measures, along with the traditional CAPM-based WACC measure, to a broad sector-based cross section from 1972 to 2015. Results show that traditional CAPM-based WACC estimates consistently lie between the new firm and market-based WACC estimates. The central positioning of CAPM WACC supports its use as a conservative hurdle rate estimate for firms and a conservative expected return estimate for investors relative to actual returns.

Keywords:

• cost of capital
• WACC
• CAPM
• return
• industry

AMS Subject Classifications:

• G11
• G12
• G31
• G32
• G35
• C22

Public Interest Statement

This work introduces two new equity finance measures to provide perspective on the troublesome equity component of a firm’s overall cost of capital. The results confirm that the common equity finance measure, CAPM, is a fair measure for use in computing the overall cost of capital. The results also show that firm–investor cash flows differ significantly from CAPM predictions and actual market returns. In particular, the results suggest that market participants play a significant role alongside firms in actual market returns. Other results of this study provide new perspective on why small firms tend to have higher returns than large firms and raises questions on the role of firm cash flow generation in actual market returns. Finally, the comprehensive sector-based cross-sectional data can serve as a reference for practitioners in their cost of capital estimations.

Acknowledgements

The author is grateful to research presentation attendees who provided feedback helpful in guiding the direction of this paper. The author also extends gratitude to the anonymous reviewer for suggestions that improved this paper.

Notes

An earlier version of this paper was presented at the November 5, 2012 research seminar at California State University Sacramento.

1 http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

2 That is, values above (below) the upper (lower) 1% tail value are replaced with the 1% tail value.

3 See the Bloomberg news article http://www.bloomberg.com/news/articles/2013-09-11/verizon-plans-49-billion-bonds-in-largest-company-offering-ever

Additional information

Funding

The author received no direct funding for this research.

Notes on contributors

David J. Moore

David J. Moore , PhD, is Professor of Finance at California State University, Sacramento. Previously, Moore was a visiting professor of Finance at The University of Memphis and a graduate assistant at the University of Tennessee. His research interests include connecting aggregate productivity to asset prices, momentum portfolio returns, option theory applied to loan restructuring, and sovereign borrowing entities to remedy sovereign debt non-performance. He presented portions of this research at the Global Business & Economics Conference in both Cambridge, UK and Oxford, UK as well as numerous research seminars in the United States. His published research appears in internationally respected journals including the Journal of Mathematical Finance, the Journal of Financial Risk Management, and Financial Study Association Rotterdam Forum. He also serves as Executive Director of the California State University, Sacramento Student Investment Fund and as Managing Director of Quantitative & Investment Research at Wahdy Altahan Financial.