Corporate Finance: Cost of Capital

The cost of capital sits at the center of corporate finance because it translates risk into a discount rate. Whether you are valuing a business, deciding between projects, or setting hurdle rates, the number you choose determines what looks profitable and what does not. Many valuation mistakes come from treating the discount rate as a plug or from mixing book and market values when estimating the firm’s financing mix. A good cost of capital estimate is not “precise,” but it should be defensible, internally consistent, and aligned with how investors price risk.

What “cost of capital” actually means

A company funds itself with a combination of equity and debt (and sometimes preferred equity). Each source has a required return:

• Cost of equity: the return shareholders demand given the risk of the firm’s cash flows.
• Cost of debt: the yield lenders require, adjusted for the tax deductibility of interest in many jurisdictions.

When these are combined in the proportions the market assigns to the firm’s capital, you get the weighted average cost of capital (WACC). WACC is commonly used as the discount rate for free cash flow to the firm (FCFF), because FCFF is available to all capital providers.

WACC and why market values matter

The standard form of WACC is:

$$\text{WACC}=\frac{E}{D+E}{R}_e+\frac{D}{D+E}{R}_d(1-T_c)$$

Where:

• $E$ = market value of equity
• $D$ = market value of debt (often approximated)
• $R_e$ = cost of equity
• $R_d$ = pre-tax cost of debt
• $T_c$ = corporate tax rate (when interest is tax-deductible)

The book value vs market value trap

A frequent error is weighting debt and equity using book values from the balance sheet. Book values reflect historical issuance and accounting conventions, not what investors currently pay for those claims. WACC is an opportunity cost, so it should use market weights whenever possible.

Practical implications:

• If equity has appreciated, book equity may be far below market equity. Using book weights can overweight debt, artificially lowering WACC and inflating valuation.
• For firms with significant share repurchases, book equity can even be negative, which makes book-weighted WACC nonsensical.

A workable approach is:

• Use market capitalization for equity.
• Use market value of debt if traded; otherwise approximate using the debt’s yield and maturity profile (or treat book as a rough proxy when the debt is near par and rates have not moved dramatically).

Cost of equity: CAPM as the standard baseline

The most common framework for estimating $R_e$ is the Capital Asset Pricing Model (CAPM):

$$R_e=R_f+\beta (R_m-R_f)$$

Where:

• $R_f$ = risk-free rate
• $\beta$ = equity beta (systematic risk relative to the market)
• $(R_m-R_f)$ = equity market risk premium

CAPM is popular because it is intuitive and widely accepted in practice. The key is not the formula, but the discipline in choosing inputs.

Choosing a risk-free rate

The risk-free rate should match the currency and time horizon of the cash flows:

• If you forecast and discount cash flows in USD, use a USD risk-free rate (often a government benchmark).
• Align maturity with duration of the cash flows. For long-lived firms, analysts often reference longer-term government yields.

Estimating beta: what can go wrong

Beta is often estimated from historical stock returns, but raw regression betas can be noisy, especially for smaller firms or those with changing business models.

Practical steps to improve beta estimates:

• Use an appropriate lookback window and frequency that balances sample size and relevance.
• Consider industry or peer betas to reduce firm-specific noise.
• Adjust for capital structure. If you use a peer group, you typically:

1. Unlever peer betas to get asset (business) risk.
2. Re-lever to the target company’s capital structure.

Conceptually, the business risk should drive the base beta, while leverage amplifies equity risk.

Market risk premium: keep it consistent

The equity risk premium should be consistent with your choice of risk-free rate and with how your organization typically values assets. The biggest problem is inconsistency, for example using a short-term risk-free rate with a premium implicitly built for long-term horizons, or mixing regional assumptions.

Cost of debt: the market’s pricing of credit risk

The cost of debt is the current required yield on the company’s borrowing, not the coupon rate on existing debt. Lenders care about default risk, recovery, and covenants; markets express that through spreads over a benchmark.

Common approaches:

• Traded debt yield: if the firm has actively traded bonds, use the yield to maturity as a starting point.
• Credit spread approach: estimate a spread based on an implied or actual credit rating, then add it to a risk-free benchmark of similar maturity.
• Synthetic rating: infer credit quality from interest coverage ratios or other credit metrics, then map to typical spreads.

After-tax cost of debt and taxes

Interest is often tax-deductible, so the effective cost is $R_d(1-T_c)$. Two cautions:

• Use the marginal tax rate relevant to incremental earnings, not necessarily the historical effective rate.
• If the firm is not expected to pay taxes (for example, persistent losses), the tax shield may be less valuable in the near term. The mechanics should match the economics.

Capital structure effects: what changes WACC

WACC is not fixed. It changes with:

• Leverage: more debt increases the weight on cheaper after-tax debt, but raises equity risk (and can raise debt costs as credit risk rises).
• Business risk: changes in operating leverage, customer concentration, or cyclicality can affect beta and credit spreads.
• Market conditions: risk-free rates, equity premiums, and credit spreads move over time.

A common misconception is that increasing debt always decreases WACC because debt is cheaper. In reality, the marginal cost of both equity and debt can rise as leverage increases. The firm’s “optimal” capital structure, if it exists, reflects a balance between tax benefits and expected distress costs, plus strategic flexibility.

Target vs current capital structure

For valuation, analysts often use a target capital structure that reflects what the business can sustain over the long run, rather than today’s temporary mix. This is especially important when:

• The company is mid-recapitalization.
• Recent market moves have shifted equity value substantially.
• The firm is transitioning between growth stages.

The crucial point is consistency: if your cash flows assume a stable leverage policy, your WACC should be based on the same.

Matching the discount rate to the cash flows

Many errors are not “bad WACC math,” but using the wrong discount rate for the cash flow definition:

• FCFF should be discounted at WACC.
• Free cash flow to equity (FCFE) should be discounted at cost of equity __MATH_INLINE_12__, because it is after debt cash flows.
• If leverage is expected to change materially over time, a constant WACC may be inappropriate. In such cases, alternative methods like adjusting discount rates over time or using an adjusted present value framework may be more coherent.

A practical checklist to avoid common valuation errors

1. Use market weights for $E$ and a market-based estimate for $D$ when feasible.
2. Ensure currency consistency across risk-free rate, cash flows, and risk premium.
3. Sanity-check beta using peer comparisons and business logic, not just regression output.
4. Use current borrowing costs, not historical coupon rates.
5. Apply taxes thoughtfully using marginal rates and realistic tax-paying capacity.
6. Match discount rate to cash flow type (FCFF with WACC, FCFE with $R_e$).
7. Document assumptions so the discount rate is explainable, not a black box.

Why getting the cost of capital “mostly right” matters

Discount rates compound small mistakes. A modest change in WACC can swing valuation materially, especially for businesses with long-duration cash flows. The goal is not to find a single perfect number, but to build a rate that reflects market opportunity costs, aligns with the firm’s risk and financing policy, and remains consistent with the cash flows being discounted. When those pieces fit, WACC becomes a tool for decision-making rather than a source of hidden valuation error.