usingtheunleveredcostofequityasthecostofcapitalwill
yield an incorrect estimate of value.
Implied Costs of Capital
In the subsectionon the cost of equity, we computed the
impliedcostofequityforindividualcompaniesbytakingthe
marketpriceandexpectedcashflowstoequity(ordividends)
asagivenandsolvingfortheinternalrateofreturn.Wecan
useasimilarapproachtoestimatethecostofcapitalforan
individualfirm,substitutingthevalueofthefirmforthevalue
ofequity andthecash flowstothefirmfor cashflowsto
equity.Theinternalrateofreturn(wherethepresentvalueof
thecashflowsto thefirmequate tothevalueofthefirm)
would be the implied cost of capital.
As with the implied cost of equity, this approach is not
particularlyusefulforanindividualfirm.Usingtheimplied
cost of capital to value the firm will generate the not
surprising conclusion that the firm is correctly valued.
However,wecancomputetheaverageimpliedcostofcapital
acrosslargenumbersoffirmsinasectorandusethisindustry
averageasthecostofcapitalforvaluingindividualfirms.We
are assuming that the cost of capital does not vary much
acrossfirmsthatoperateinthesamebusinessandthatmaybe
apotentialprobleminsectorswheretherearebigdifferences
in operating and financial risk across companies.
Weighted Average Cost Approach
The most widely used approach to estimating the cost of
capital involves estimating the costs of the nonequity
componentsofcapital,includingdebtandpreferredstockin