Implied cost of capital: how to calculate it and how to use it

The article discusses the importance of implied cost of capital as a tool capable of guiding choices in valuations based on the income approach and the market approach. In particular, the article suggests the use of implied cost of capital for two main purposes: a) as a test of reasonableness of the cost of capital estimated on the basis of the CAPM and the WACC (MM formula); b) as a test of valuations using multiples. The article consists of three parts: part one highlights the criticalities in the application of the CAPM and the MM formula in the current market context (low risk-free interest rates, unstable beta coefficients, volatile ERPs, risky debt); part two outlines the ways in which implied cost of capital is estimated while part three illustrates the use of implied cost of capital by reference to a listed ultinational company (for which it is hard to determine in advance whether the expected return depends on local or global factors, i.e. risk-free rate, ERP and beta) and a listed company operating in the luxury goods sector (to test the reasonableness of the estimate that would be obtained by using multiples).