Dale Wettlaufer

Charlotte Lane Capital

November 30, 2015

I often say discussions about weighted average cost of capital (WACC) are among the most boring because they become religious: You get orthodoxy, fervent Messianism, and the truly fringe. Understanding I may well fall somewhere near the fringe, I will add to the cacophony.

Conclusions

The beta component of CAPM is a plug that came about in an era of expensive computing power. It might backtest well, but it’s not explanatory.

The mysterious equity risk premium is really not that mysterious. I believe credit spreads account for the majority of the ERP.

In this paper, I therefore propose an alternate theory of calculating the cost of equity as well as WACC. I have employed this approach in modeling since 2009-2010, having been informed in my thinking by the incredible values available in distressed debt at that time. Major influences also include Rob Arnott and the inestimable Peter Bernstein, Michael Mauboussin, and in working on private equity investments at that time.

Using expected return data extracted from the credit market, one can discount cash flows with more sensitivity toward risk-adjusted returns than the brittle CAPM calculation can hope to address.

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