The Cost of Capital

The cost of capital is the return required for bearing the risk of the assets being financed. The course connects business risk to the claims of shareholders and lenders, then constructs WACC using market-value weights.

Course purpose

The decision examined

A discount rate is neither the coupon on the latest loan nor an arbitrary prudence premium. It is an opportunity cost for comparable risk, currency and maturity, and it must match the perimeter of the cash flows.

Objectives

Learning outcomes

Interpret cost of capital as an opportunity cost.
Distinguish cost of equity from cost of debt.
Construct a WACC consistent with the cash flows.

Concepts

Key concepts

Required return
Cost of equity
Cost of debt
WACC
Market weights
Tax shield

Syllabus

Course structure

Opportunity cost
Business risk
Equity
Debt
Weighting
Application perimeter

Extract

Analytical framework

Weight the financing claims

For market values of equity E and debt D, cost of equity k_e, cost of debt k_d and tax rate T:

Weighted average cost of capital

WACC = ED+Ek_e + DD+Ek_d(1−T)

Book weights do not measure the capital currently exposed by investors. The selected weights should represent the forward-looking target financing structure.

Full course

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