The ratio between debt and equity in the cost of capital calculation should be the same as the ratio between a company’s total debt financing and its total equity financing. Put another way, the cost of capital should correctly balance the cost of debt and cost of equity. This is also known as the weighted average cost of capital, or WACC.
Cost of Debt
Companies sometimes take out loans or issue bonds to finance operations. The cost of any loan is represented by the interest rate charged by the lender. For example, a one-year, $1,000 loan with a 5% interest rate “costs” the borrower a total of $50, or 5% of $1,000. A $1,000 bond with a 5% coupon costs the borrower the same amount.
The cost of debt does not represent just one loan or bond. Cost of debt theoretically shows the current market rate the company is paying on its debt. However, the real cost of debt is not necessarily equal to the total interest paid, because the company is able to benefit from tax deductions on interest paid. The real cost of debt is equal to interest paid less any tax deductions on interest paid.
The dividends paid on preferred stock are considered a cost of debt, even though preferred shares are technically a type of equity ownership.
Cost of Equity
Compared to cost of debt, the cost of equity is complicated to estimate. Shareholders do not explicitly demand a certain rate on their capital in the way bondholders or other creditors do; common stock does not have a required interest rate.
Shareholders do expect a return, however, and if the company fails to provide it, shareholders dump the stock and harm the company’s value. Thus, the cost of equity is the required return necessary to satisfy equity investors.
The most common method used to calculate cost of equity is known as the capital asset pricing model, or CAPM. This involves finding the premium on company stock required to make it more attractive than a risk-free investment, such as U.S. Treasurys, after accounting for market risk and unsystematic risk.
Weighted Average Cost of Capital
WACC takes all capital sources into consideration and ascribes a proportional weight to each of them to produce a single, meaningful figure. In long form, the standard WACC equation is:
WACC = (% equity financing) * (cost of equity) + (% debt financing) * (cost of debt) * (1 – the corporate tax rate)
The firm’s WACC is the required return necessary to match all of the costs of its financing efforts and can also be a very effective proxy for a discount rate when calculating Net Present Value, or NPV, for a new project.