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On the Weighted Average Cost of Capital

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  • Reilly, Raymond R.
  • Wecker, William E.

Abstract

The weighted average cost of capital is a widely used concept in the theoretical literature of finance as well as in the analysis of capital expenditures of business firms. The importance of the concept derives from its use as the cutoff point for investment in capital projects and as an indicator of optimal capital structure. Differences between the weighted average cost of capital and the true overall cost of capital are typically attributed to deviations of market values from book values, changes in the proportional use of specific capital sources, or alterations in the risk characteristics of the stream of payments to owners and creditors. This paper abstracts from the aforementioned problems to focus on the mathematical error of using weighted average cost of capital to represent the true overall capital cost. It is determined that, in general, the calculation of weighted average cost leads to an erroneous value of the minimum acceptable level of return. The fault lies in the general inability to express the root(s) of a polynomial as an algebraic combination of the roots of other related polynomials.

Suggested Citation

  • Reilly, Raymond R. & Wecker, William E., 1973. "On the Weighted Average Cost of Capital," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 8(1), pages 123-126, January.
    • Handle: RePEc:cup:jfinqa:v:8:y:1973:i:01:p:123-126_01
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    Cited by:

    1. Knolle, Julia, 2020. "Prosperity in a Low Interest Environment," MPRA Paper 104332, University Library of Munich, Germany.
    2. Rodolfo Apreda, 2008. "Cost of capital adjusted for governance risk through a multiplicative model of expected returns," CEMA Working Papers: Serie Documentos de Trabajo. 383, Universidad del CEMA.
    3. Ravi Thirumalaisamy, 2015. "A Study on Cost of Capital," International Journal of Empirical Finance, Research Academy of Social Sciences, vol. 4(1), pages 1-11.

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