The Relation Between the Cost of Capital and Economic Profit

This paper develops empirical estimates of the average cost of capital for 58 U.S. industries during 1990-1999. A simple, parsimonious theoretical relation between an industry’s weighted average cost of capital (WACC) and the industry’s economic profit is used to obtain empirical estimates of the WACC for these 58 industries. We show that our technique requires fewer data inputs for deriving ex post WACC estimates than the conventional (or “textbook”) cost of capital technique and can be applied to firm-level as well as industry data. We find that our estimates are positively correlated with an industry’s cost of capital estimated via conventional methods and that differences between the two sets of estimates are related to industry-specific differences in growth opportunities and profitability. The model’s estimates are also more positively related to realized stock returns and perform better in out-of-sample forecasts than estimates based on the conventional method. Overall, the results suggest our technique can be a more expedient, descriptive, and precise method of deriving estimates of an industry’s (or firm’s) weighted average cost of capital and economic profit. Estimating a firm’s weighted average cost of capital (WACC) is of critical importance to managers who evaluate investment projects for capital budgeting purposes as well as to investors who wish to assess the overall riskiness and expected return from a company’s activities for valuation purposes. For example, corporate finance textbooks typically devote several chapters to the problems of capital budgeting, cash flow estimation, and the determination of a firm’s cost of capital. However, it can be difficult in practice to obtain reliable estimates of the inputs required to perform capital budgeting as recommended by the textbooks. As Fama and French (1997, 1999) point out, some of these practical difficulties exist because there is considerable uncertainty in estimating a firm’s (or even an industry’s) cost of capital. This uncertainty is similar to the risk faced by the firm when projecting a project’s cash flow. In addition, surveys of corporate finance practitioners indicate there is wide variation in corporate WACC estimation methods, primarily due to managers’ differences in estimating a firm’s cost of equity capital (e.g., see Bruner, Eades, Harris, and Higgins, 1998). Thus, a simple, parsimonious, less-subjective, and accurate method of estimating the WACC for a firm or industry can be a useful tool to managers interested in capital budgeting problems and investment decision-making in general. We present such a method and perform empirical tests based on this technique for 58 U.S. industries. In addition, our method provides estimates of economic profit (also referred to as “economic value added” or EVA by the Stern Stewart and Co. consulting firm). These estimates of economic profit can be useful for analysts who wish to study the long-term performance of corporations before and after an important financial event. For example, our model’s economic profit estimates might be helpful in identifying (via an event study format) the long-term overor under-performance of firms issuing new securities or merging with other firms. 1 We can define a “simple” method as one that is less intensive in terms of the time and computations required to obtain a WACC estimate when compared to the conventional textbook method. Likewise, a “parsimonious, less-subjective” method can be defined as one that requires fewer inputs and/or calculations that are based on subjective judgments made by the analyst and / or the firm’s management. The conventional approach to identifying a firm’s WACC is based on estimating the costs of the individual components of the firm’s sources of financing. For example, computing the WACC for a company with debt and common equity in its capital structure entails estimating: 1) the relative weights of debt and equity in the capital structure, 2) the required after-tax return on the firm’s debt securities, and 3) the required return on the company’s common equity. One of the difficulties in implementing the above method is that it is sometimes hard to identify the correct weights of the capital structure components because the market values of many debt securities (e.g., bank loans, privately placed debt) might not be known. In addition, estimating the required returns on the debt securities can be problematic due to the general paucity of data related to corporate debt instruments. Further, as Fama and French (1997, 2002) confirm, estimating the required return on common equity can be difficult due to the statistical noise inherent in estimating an asset pricing model’s time-varying factor loadings and risk premiums. Using dividend and earnings growth models, Fama and French (2002) show that the expected equity premium for 1951-2000 is probably much lower than estimates based on realized stock returns (e.g., 2.55% – 4.32% versus the 7.43% estimate based on actual stock returns). This result is due to the statistical problems associated with the use of realized returns as proxies for expected returns. Recent results reported in Elton (1999) also suggest the use of historical returns as a proxy for ex ante returns is not appropriate when one examines the long-term performance of various securities such as U.S. government bonds and Tbills. This study addresses the issues described above by proposing a method for estimating a firm’s cost of capital that neither requires estimating the firm’s capital structure nor the firm’s required return on debt and equity securities. The approach is based on the microeconomic concept of “economic profit” first posited by Alfred Marshall (1890) over a century ago. Recent work on economic value added (EVA) by Stewart (1991) has revived interest in estimating the economic profit of a firm or 2 See Ehrhardt (1994) for an in-depth discussion of the practical application of various methods of cost of capital estimation.