Abstract

This paper investigates the differential impact of expected vs unexpected inflation on the weighted
average cost of capital (WACC) of US firms. While both measures have positive and significant
impacts on WACC, economically meaningful effects are observed only for unexpected inflation.
When WACC is disaggregated into its components, similar findings are observed for the cost of
equity, but not for the cost of debt. During periods of high inflation, unexpected inflation does
have a significant effect on the cost of debt, and its effect on the cost of equity is augmented. In
contrast with some of the recent literature that does not consider inflation, we find a negative and
significant relationship between WACC and investment levels, which is in accordance with theory.
However, we do not find a significant relationship between the cost of capital and research and
development (R&D) expenditures. This is consistent with the hypothesis that R&D decisions are
based on internal financing sources.