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Return to basics: cost of capital depends on free cash flow

Author

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  • Ignacio Velez-Pareja

Abstract

Most popular corporate finance textbooks and practitioners present the WeightedAverage Cost of Capital WACC calculation as independent from the Free Cash Flow.It is a common use that practitioners calculate a WACC a priori and use it independentlyfrom the firm value (this is, from FCF). In this note we show that FCF affects WACC andthat this interrelationship creates circularity, but we show how it can be solved in a veryeasy way. There are two appendixes: one explaining the circularity issue and another one forderiving the proper formulation of the cost of equity.

Suggested Citation

  • Ignacio Velez-Pareja, 2008. "Return to basics: cost of capital depends on free cash flow," Proyecciones Financieras y Valoración 5097, Master Consultores.
    • Handle: RePEc:col:000463:005097
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    More about this item

    Keywords

    Weighted average cost of capital; WACC; firm valuation; capital budgeting; equity cost of capital; circularity;
    All these keywords.

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • H43 - Public Economics - - Publicly Provided Goods - - - Project Evaluation; Social Discount Rate

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