The weighted average cost of capital has significant bearing on corporate investment, but the form of its impact depends on how the cost of equity is being measured. The CAPM suggests that firms with a high cost of equity tend to invest more. In contrast, the implied cost of capital (ICC) model suggests that the ICC may better reflect the time-varying required return on capital.
The authors study how the weighted average cost of capital (WACC) affects corporate investment and firms’ capital budgeting decisions. They provide strong evidence that the WACC matters for corporate investment. Although firms with a high cost of debt invest less, the impact of the cost of equity on investment depends on how it is measured. When measured by the implied cost of capital (ICC) model, a high cost of equity suggests lower investment. However, the opposite is expected if the CAPM is used to measure cost of equity.
How Is This Research Useful to Practitioners?
The authors study the impact of the WACC and its components on firm-level investment. They provide strong empirical evidence that the WACC has an impact on corporate investment, but the form of the impact is not always evident. Firms with a high cost of debt invest less. The impact of the cost of equity depends on how it has been measured. Factor models, such as the CAPM, predict that firms with a high WACC tend to invest more. This may be because factor models tend to generate a cost of equity that is positively related to corporate investment.
In contrast, when the ICC model (which uses the Gordon growth model and the residual income model) is used to infer the cost of equity, the WACC becomes significantly negatively related to firm-level investment. The authors find that both the ICC and the CAPM generate a cost of equity that is statistically significant. The ICC provides a good reflection of the time-varying required return on equity. The CAPM version of the cost of equity operates through a mechanism that falls outside traditional models, which could lead to misvaluation. Further research might be needed in this respect.
Chief financial officers could find the conclusions of this research useful. The impact of cost of equity on overall firm-level investment seems to depend on the model used to estimate it. The CAPM tends to suggest that a high WACC would result in high corporate investment. Because this model is widely used despite its various limitations, chief financial officers should exercise caution when basing capital-budgeting decisions solely on CAPM results.
How Did the Authors Conduct This Research?
The authors study how the WACC affects corporate investment using firm-level data (covering 9,714 firms) from 1955 to 2011. The firm-level data come from Compustat and CRSP. Utility and financial firms, as well as firms with negative average cash flow, are omitted from the sample. The average firm appears in the data for 24.25 years. The average cost of equity over all firms and all years is around 0.2. The mean corporate cost of debt is found to be about half of the cost of equity.
Using regression analysis, the authors find that the WACC has a positive and significant impact on investment. They also find that the coefficient of the CAPM cost of equity is consistently positive and statistically significant, even after taking into account measurement error. They do not find evidence of negative autocorrelation. The analysis also applies for firms with different levels of leverage and size.
The authors then consider the ICC version of the cost of equity. Following regression analysis, they find that the ICC generates a WACC with a negative and significant sign, implying a negative association with firm-level investment. Overall, they note that the implied cost of equity affects corporate investment differently than that obtained from factor models. The authors then conjecture that the ICC model provides a good indication of the time-varying required return on equity.
It is generally expected that a high WACC would result in low firm-level investment. Although this would apply in case of high cost of debt, it is less evident when cost of equity is being considered. Much would depend on the model being used to calculate cost of equity. Although I have concerns that the data used in the analysis exclude firms with negative cash flow and do not cover a very long and extensive period, the authors demonstrate how two different models can make completely different predictions when cost of equity is being considered. Bearing in mind the numerous limitations of the CAPM, some caution may be warranted when using this model.