Cost of Capital: The Basics
Every business needs funding, which comes from either equity (shares) or debt (loans or notes) and most businesses use a mix of both. Cost of capital represents the minimum return investors expect, and helps in evaluating investment decisions.
If a company has only equity, the cost of capital equals the cost of equity.
If a company uses both debt and equity, the overall cost of capital is calculated using the Weighted Average Cost of Capital (WACC).
Weighted Average Cost of Capital (WACC)
WACC is the weighted average cost of equity and the after-tax cost of debt.
Where:
E = Market value of equity
D = Market value of debt
Re = Cost of equity
Rd = After-tax cost of debt
Example:
Company A has $10M equity and $4M debt. Cost of equity is 25%, after-tax cost of debt is 12%.
This means Company A must earn at least 21.3% on its invested capital to create value.
Cost of Debt
Debt has a tax benefit because interest is tax deductible. The after-tax cost of debt is:
If multiple loans exist at different rates, a weighted average cost of debt should be calculated.
Cost of Equity
The cost of equity reflects the return required by investors for taking the risk of investing in the company. The Capital Asset Pricing Model (CAPM) is widely used to calculate cost of equity:
Where:
Risk-free rate (Rf): The return on government bonds, considered virtually risk-free.
Beta (β): Measures the risk of the business relative to the market. It reflects how sensitive the company’s returns are to market movements.
Market risk premium (Rm−Rf): The additional return investors expect for taking market risk.
Understanding Beta
Beta can be tricky. In simple terms, it tells us how risky a business is compared to the overall market:
β>1 → more volatile than the market
β<1 → less volatile than the market
However, beta from publicly listed comparable companies includes both business risk and financial risk from leverage (debt). To use beta for valuing a target company, we adjust it.
Step 1: De-gearing Beta (Un-levering)
Removes the effect of debt to isolate the business risk (unlevered beta: βu)
Where:
βl = levered beta of comparable company
t = corporate tax rate
D/E = debt-to-equity ratio of the comparable company
Debt increases risk for equity holders. Removing debt shows the risk of the business itself, independent of financing.
Step 2: Re-gearing Beta (Levering)
Adjust the unlevered beta to reflect the target company’s capital structure:
Where:
D/E = debt-to-equity ratio of the target company
T = tax rate applicable to the target company
This gives the levered beta for the target company, which we can use in CAPM to calculate the cost of equity.
SCENARIO
Cost of capital for TargetCo, a private retail company with the following details:
Financial Structure:
Equity: $10m, Debt: $4m, corporate tax rate: 20%, average interest rate: 10%
Equity Market Information:
Risk free rate (Rf): 5%, Market risk premium (Rm−Rf): 6%
Comparable Public Companies (Tax rate of 25%)
# | Levered Beta (βl) | D/E |
1 | 1.2 | 0.4 |
2 | 1.5 | 0.6 |
3 | 1.3 | 0.5 |
Therefore:
- Debt to Equity ratio of Target Co. 4m / 10m = 0.4
- After-tax cost of debt: 10% x (1-0.2) = 8.0%
Using comparable public company information let compute β for TargetCo.
# | Computation | Result |
1 | 1.2 / (1 + 0.75*0.4) | 0.923 |
2 | 1.5 / (1 + 0.75*0.6) | 1.034 |
3 | 1.3 / (1 + 0.75*0.5) | 0.946 |
This gives us average unlevered β of 0.968. Therefore levered β for TargetCo is 0.968×(1+0.8∗0.4)= 1.278
Cost of Equity using CAPM for TargetCo:
Re=Rf+β(Rm−Rf) = 5% + 1.278 x 6% = 12.67%
Weighted Average Cost of Capital (WACC) for TargetCo:
WACC=((E x Re) + (D x Rd))/E+D = ((10 x 12.67%) + (4 x 8%))/14 = 11.34%
TargetCo must earn 11.34% on invested capital to satisfy both equity and debt investors.
Conclusion
In summary, the cost of capital represents the minimum return a business must earn to create value for its investors. By understanding how debt, equity, risk, and capital structure interact, companies can make better investment, financing, and valuation decisions. WACC serves as a practical benchmark for assessing projects, valuing businesses, and ensuring that growth initiatives generate returns above the expectations of both lenders and shareholders.