Cost of Capital
Cost of capital is the minimum return a project must earn to leave shareholder wealth unchanged. It is a forward-looking, risk-adjusted hurdle rate, not an accounting cost.
Components
- Cost of debt: kd = interest × (1 − tax rate) for tax-deductible, irredeemable debt; for redeemable debt use the IRR of after-tax cash flows.
- Cost of preference: dividend/net proceeds.
- Cost of equity: CAPM, ke = rf + β(rm − rf), or dividend growth, ke = D1/P0 + g.
- Retained earnings carry an opportunity cost equal to ke; they are not free.
- WACC = Σ(weight × after-tax component cost), using market-value weights where possible.
Worked example
Debt is 40% of capital, equity 60%. Pre-tax debt cost is 10%, tax 25%, so after-tax kd = 7.5%. Risk-free is 7%, beta 1.2, market risk premium 6%, so ke = 7 + 1.2×6 = 14.2%. WACC = 0.40×7.5 + 0.60×14.2 = 3.00 + 8.52 = 11.52%. A project with the firm's average risk must clear 11.52%; a safer project may use a lower rate, a riskier one a higher rate.
Traps
Do not use pre-tax debt in WACC; do not use coupon instead of yield when market price differs from par; do not add flotation costs to the cost of equity without adjusting proceeds; and do not use historical book weights when market weights are available.