Cost of Capital

February 15, 2023

Cost of Capital

Consilient Observer

Cost of Capital

February 15, 2023

A Practical Guide to Measuring Opportunity Cost

This is a practical guide to estimating the weighted average cost of capital (WACC) for a company.
The cost of capital is a measure of both expected return and the discount rate. For example, investors discount future free cash flows at the WACC to come up with a present value in a discounted cash flow model.
Our goal is to find a figure that reflects opportunity cost sensibly, is economically sound, and provides the investor and businessperson with a solution to apply to the problem.
We recommend settling on a sensible cost of capital and then allocating the bulk of analytical time and attention to thinking about the potential paths of future cash flows.

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DEFINITIONS

Free cash flow (FCF) is a measure of financial performance calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able generate after laying out the money required to maintain or expand its asset base.

Weighted average cost of capital (WACC) represents a firm’s cost of capital where each category of capital is proportionately weighted.

IMPORTANT INFORMATION

The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) and its subsidiaries and affiliates (collectively the Firm”), and may not be reflected in all the strategies and products that the Firm offers.

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