Cost of capital
Also known as: WACC, Weighted average cost of capital, Discount rate
The rate everything is discounted at, assembled from inputs that are mostly estimates of things nobody can observe.
1 · SnapshotThe one idea to remember
2 · BeginnerWhat actually happens?
Money in the future is worth less than money now. To value anything you have to decide by how much, and that decision is the cost of capital.
It is meant to be what the people funding a business require to be there. Lenders require interest. Shareholders require more, because they are paid last and can lose everything. Blend the two in proportion to how much of each the business uses, and that blend is the rate.
The problem is that only one piece of it can actually be looked up. What a government pays to borrow is published. What shareholders require is not — it has to be estimated, and reasonable people estimate it differently by whole percentage points.
Which matters enormously, because moving the rate by one point changes a valuation by roughly a quarter. Anybody can move a valuation that much without doing anything anybody could call wrong, and that is the honest reason results from this desk are quoted as ranges.
- 1
Risk-free rate1 hr
A government yield at a maturity matching the cash flows — the only genuinely observable input.
- 2
Equity risk premium1 day
What investors require above the risk-free rate, which is estimated rather than observed and disputed by several percentage points.
- 3
Beta1–2 days
How much this business moves with the market, measured from peers and adjusted for their different debt.
- 4
Cost of debt and weights1 day
What the company pays to borrow, after tax, and the mix of debt and equity assumed for the future.
- 5
Sensitivity1 day
The rate is varied, because a single figure would claim a precision that does not exist.
Which premium — The analyst decides. Reasonable estimates differ by whole percentage points, and the choice moves a valuation by a quarter.
Does the rate match the cash flows — The reviewer decides. Nominal cash flows need a nominal rate and one currency needs its own — mismatches here are the commonest structural error in the method.
Who is on the deal
| Who | Side | What they are actually for |
|---|---|---|
| The analyst | Neither | Assembles a rate from inputs that are mostly estimates of things nobody observes. |
| The equity market | Neither | Provides the beta and, indirectly, the premium — both measured from the past. |
| The credit market | Neither | Provides the cost of debt, which is the one input with a live price. |
| Whoever disagrees with the answer | Both | Will start here, because a percentage point moves the valuation by a quarter. |
- Desk
- Valuation & Deal Analysis
- Only observable input
- The risk-free rate
- Most disputed input
- The equity risk premium
- Effect of one percentage point
- Roughly a quarter of the valuation
- Correctly presented as
- A range, with the answer sensitised across it
What decides whether it completes
Not how hard this is, and not a rating — there is deliberately no total. It says which of five blockers decides whether this transaction happens at all, in the same order on all 70 transaction types so they can be compared. This publication's own reading; see the notice below.
- Pricedecides it
- Financingbarely applies
- Approvalbarely applies
- Diligencematters
- Executionmatters
What decides it here. Almost every input is an estimate of something unobservable, and reasonable people differ by whole percentage points on the equity risk premium alone. The structural errors are quieter: a nominal rate against real cash flows, or one currency's rate against another's forecast.
3 · IntermediateHow it runs in practice
The formula
What the symbols mean
- Cthe price of a call option
- Ean expected value
- Va value
- rthe interest rate, per year
- Dduration: how far a bond's cash flows sit in the future
- ta point in time
The cost of equity weighted by how much equity, plus the after-tax cost of debt weighted by how much debt. Interest is generally deductible, which is why debt is cheaper — and that tax shield is a real part of why leverage exists at all.
The cost of equity
What the symbols mean
- rthe interest rate, per year
- betahow much a holding moves with the market
- The risk-free rate — a government yield at a maturity matching the cash flows. Observable.
- The equity risk premium — what investors require above it for holding shares. Estimated from history, from surveys, or implied from current prices. Not observable, and the three approaches disagree.
- Beta — how much this business moves with the market. Measured from listed peers, then adjusted to strip out their debt and reapply the target's.
The weights are the future, not the present
The proportions of debt and equity should be what the business will use over time, not what it happens to have today. A company that is temporarily very leveraged is not permanently cheap to fund, and using today's mix builds a temporary condition into a permanent valuation.
Which is why the buyout model looks different
In a leveraged buyout analysis the capital structure changes every year by design, so a single blended rate does not describe it. That model discounts the equity cash flows at the equity return instead, which is the honest response to a structure that is deliberately not stable.
4 · AdvancedThe numbers & the documents
The errors that are structural rather than debatable
- Nominal against real. Cash flows that include inflation must be discounted at a rate that includes it. Mixing them is a large and silent error.
- Currency mismatch. Cash flows in one currency need a rate built in that currency, or the forecast must be converted first at forward rates.
- Double-counting risk. Adding a premium for company-specific risk to a rate that already reflects it, and then also using a conservative forecast, penalises the same risk twice.
- A firm-wide rate for a divisional decision. A group whose divisions have different risks should not discount all of them at one rate — see the sum of the parts.
Beta, and what it does and does not measure
Beta measures how a share has moved with the market. It says nothing about the risk of the business failing, about illiquidity, or about anything specific to this company — the theory behind it holds that those are diversifiable and therefore not compensated.
Whether that holds for a private company being bought by a fund with everything in one place is a genuine question, and the practical answer is a size or illiquidity premium, which is a judgement dressed as an input. Say which it is.
Why practitioners narrow the range by convention
Because a rate that can be defended anywhere between seven and eleven per cent produces a valuation range too wide to negotiate with. So firms adopt house conventions: a stated premium, a stated approach to beta, a stated tax rate. Those conventions are not more correct than the alternatives; they are consistent, which lets two analyses be compared.
Knowing that the convention is a convention rather than a discovery is the whole of the sophistication here.
What to do about it
Sensitise, and publish the sensitivity. A table of value across a range of rates and growth rates is more honest than a single figure and more useful in a negotiation, because it shows which assumptions the two sides actually disagree about.
The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.
5 · Desk notesHow people on the deal think about it
Now say it back
Close the page and give Cost of capital in four sentences. It takes a minute and it is the only way to find out whether reading it was enough.
- Who wants what — name both sides and what each one is actually trying to get.
- What has to happen, in order — the three or four stages, not the whole timetable.
- Where the money comes from — cash, new shares, or borrowed; somebody has to fund it.
- What kills it — the ordinary way, not the dramatic one.
Where this transaction shows up elsewhere
- EasyActivist campaignDealA small stake and a public argument
- MediumDiscounted cash flowDealThe only method that values the business itself
- MediumValuationDeskThe arithmetic underneath every transaction: discounted cash flow, comparables, precedent transactions, the buyout…