Cost of Capital

15-FEB-2023

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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.

This material is for the benefit of persons whom the Firm reasonably believes it is permitted to communicate to and should not be forwarded to any other person without the consent of the Firm. It is not addressed to any other person and may not be used by them for any purpose whatsoever. It is the responsibility of every person reading this material to fully observe the laws of any relevant country, including obtaining any governmental or other consent which may be required or observing any other formality which needs to be observed in that country.

This material is a general communication, which is not impartial, is for informational and educational purposes only, not a recommendation to purchase or sell specific securities, or to adopt any particular investment strategy. Information does not address financial objectives, situation or specific needs of individual investors.

Any charts and graphs provided are for illustrative purposes only. Any performance quoted represents past performance. Past performance does not guarantee future results. All investments involve risks, including the possible loss of principal.

Prior to making any investment decision, investors should carefully review the strategy’s relevant offering document. For the complete content and important disclosures, refer to the article pdf.