Applying the Empirical Average Cost of Capital : Estimating the Cost of Funds at the Firm and Industry Levels

This paper 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 primarily 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. In addition, the model can be estimated using either time series, cross-sectional, or panel data sets. Estimates of the EACC for 58 U.S. industries are compared to five conventional “textbook” estimates of the weighted average cost of capital currently published by Duff & Phelps. We find the EACC yields forecasts of future net operating profit after taxes that compare favorably to the five published measures of the weighted average cost of capital, as well as the average and median of these measures. We also demonstrate how the EACC method can be used within corporate finance research via a conventional event study that estimates the impact of the 2010 Deepwater Horizon oil rig disaster on BP's and its industry's cost of capital. In addition, we show how our EACC method can be applied within an investments context via a conventional asset pricing test that uses our industry EACC estimates to construct Carhart-type long-short portfolios and find that our approach can generate a significant alpha of +38.4 bps per month. 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