Rethinking capital budgeting: embedding ex-ante alpha in the cost of capital

Traditionally, the cost of capital is treated as equal to the full expected return. This Note introduces an effective cost of capital that adjusts the benchmark rate for a gain of capital term capturing the systematic effect of bias in cash-flow forecasts. The gain of capital provides a horizon-specific proxy for the systematic component of alpha, estimated for a given asset class and horizon and used ex ante as a correction within DCF valuation. In this way, the structural component of forecast bias is corrected, while residual ex post alpha remains possible but should be smaller. The framework separates valuation from capital budgeting: biased cash flows are discounted at the effective cost of capital, while project acceptance compares that effective rate to the risk-free rate, providing a more disciplined investment threshold.