Cost of Capital (Debt, Equity, WACC)

Every business needs capital, the money to buy assets and run operations. That capital comes from two sources: debt (banks, bondholders) and equity (shareholders). Both have a cost. Lenders want interest; shareholders want returns. The blended cost of all these funds is the Weighted Average Cost of Capital (WACC).

WACC is the minimum return a company must earn on its investments to satisfy all capital providers. If a company earns exactly its WACC, it is creating zero economic value, just enough to keep investors from leaving. To create value, it must earn above WACC.

For an analyst, WACC is the discount rate in a DCF model. Small changes in WACC have large effects on estimated value, which is why debates about the right WACC are a regular feature of equity research.

WACC formula:

WACC = (E/V) × Ke + (D/V) × Kd × (1 − t)

Where: E = market value of equity, D = market value of debt, V = E + D, Ke = cost of equity, Kd = cost of debt (pre-tax), t = corporate tax rate.

Cost of Equity (Ke), CAPM: Ke = Rf + β × (Rm − Rf)

• Rf (Risk-free rate): Typically the 10-year Indian G-sec yield
• β (Beta): A measure of the stock's sensitivity to market movements. Beta of 1.2 means the stock moves 1.2% for every 1% move in Nifty
• Rm − Rf (Equity Risk Premium): The additional return investors demand for holding equities over G-secs. For India, this is typically estimated at 5–7%

Cost of Debt (Kd): Use the company's marginal borrowing rate, the rate on new debt, not historical average. For rated companies, derive from the spread over G-sec for that credit rating. After-tax cost = Kd × (1 − t) because interest is tax-deductible.

Example: Rf = 7%, β = 1.1, ERP = 6% → Ke = 7% + 1.1 × 6% = 13.6%. Pre-tax Kd = 10%, t = 25% → After-tax Kd = 7.5%. Capital structure: 70% equity, 30% debt. WACC = 0.7 × 13.6% + 0.3 × 7.5% = 9.52% + 2.25% = 11.77%.