Cost of capital is the return the providers of a business’s capital require in exchange for supplying it, and therefore the minimum return the business has to earn on that capital before it is creating value for them. Lenders state their leg of it as a rate, and equity holders set theirs by what their money could earn elsewhere at the same risk. Blend the two in the proportions that actually fund the business and you get one rate. That rate is what a valuation, a capital budgeting decision or a discounted measurement runs against.
The Debt Leg and the Equity Leg
The cost of debt is observable. It is the rate the business pays on its borrowings, and the rate it carries is the one after fees and discount are spread across the life of the debt, which effective interest rate works through.
The cost of equity is not observable, because nobody invoices for it. It is what owners require for leaving money in the business instead of putting it somewhere of similar risk, so it is estimated rather than read off a document.
That asymmetry shows up in the way an income statement is built. Regulation S-X sets out the line items that should appear on the face of the statements of comprehensive income filed with the SEC, interest and amortization of debt discount and expense is caption 8, and nothing on the list charges the business for the equity it uses (17 CFR 210.5-03), a caption set that governs SEC filings rather than every set of books. Net income is struck after the debt leg has been paid and before the equity leg has been met, which is where the subtraction chain in net income stops.
The Weighted Average Form
The weighted average cost of capital, or WACC, is the blend of the two legs, weighted by how much of the total capital each one supplies.
WACC = (E / V) x Re + (D / V) x Rd x (1 - t)
E market value of equity
D market value of debt
V E + D, the total capital in use
Re cost of equity, the return equity holders require
Rd cost of debt, the pre-tax rate on the borrowings
t the marginal tax rate that applies to the interest deductionE and D are market values rather than book values, because the question is what today’s providers of capital require on what they have at stake today, the same market view of the funding that enterprise value is built on. V is the two added together, so the weights on either side sum to one. Re is the estimated return equity holders require, and it is the softest input in the formula. Rd is the rate on the borrowings, firmer than Re because a lender will quote it, read at what the business would pay on that debt today rather than at a coupon fixed years ago. The final term, one minus t, applies to the debt leg alone.
Why the Debt Leg Is Stated After Tax
Interest is deductible, so a dollar of interest costs the business less than a dollar. Interest paid or accrued within the taxable year on indebtedness is allowed as a deduction in computing taxable income, except as sections 264 to 267 otherwise provide (Treasury Regulation 1.163-1(a)). That deduction, and not a convention, is the whole reason the debt leg carries the one minus t factor.
The factor assumes the deduction is actually available, and Internal Revenue Code section 163(j) is where the assumption can fail. The amount allowed as a deduction for business interest expense for the taxable year cannot exceed the sum of the taxpayer’s business interest income, 30 percent of adjusted taxable income, and floor plan financing interest expense (Treasury Regulation 1.163(j)-2(b)(1)). Adjusted taxable income means the taxpayer’s tentative taxable income adjusted as the regulation directs, starting with adding business interest expense back (Treasury Regulation 1.163(j)-1(b)(1)).
Two things soften that. A taxpayer other than a tax shelter, as section 448(d)(3) defines that term, is outside the limitation in any year it meets the gross receipts test of section 448(c), and disallowed business interest expense is carried forward to the succeeding taxable year rather than lost (Treasury Regulation 1.163(j)-2). So where the limitation does bite, the shield is delayed, and the honest after-tax rate sits between the pre-tax rate and the one the formula produces.
A Worked Example
Say a business is funded with the mix below, and its marginal rate is the one stated.
Debt 600,000 at 8.0% before tax
Equity 1,400,000 at 13.0% required
Marginal tax rate 21.0%
V = 600,000 + 1,400,000 = 2,000,000
D / V = 600,000 / 2,000,000 = 0.30
E / V = 1,400,000 / 2,000,000 = 0.70
Rd after tax = 8.0% x (1 - 0.21) = 6.32%
WACC = (0.70 x 13.0%) + (0.30 x 6.32%)
= 9.10% + 1.896% = 10.996%A project inside that business returning less than the blended rate, measured after tax as the blend itself is, leaves its capital providers short even when it books a profit, because the equity leg never reaches the income statement to be subtracted. Shift the mix toward debt and the blend falls, which is the arithmetic behind cheap borrowing lifting owner returns, read from the ratio side in equity multiplier. The blend falls only while the required returns stay put, and they rarely do, since more debt makes both legs riskier.
Where a Firm Meets It
Cost of capital is an analytical input, not a reported figure, so it never appears as a line item on a financial statement. It arrives inside a model instead.
Discounted measurements are the common case. A present value measurement that fully captures the economic differences between assets would necessarily include the time value of money represented by the risk-free rate of interest, and the price for bearing the uncertainty inherent in the asset or liability, among its five elements (FASB Concepts Statement No. 7, paragraph 23). Those are the pieces a required return is assembled from. Impairment measurement reaches for the same machinery whenever fair value has to be estimated from expected cash flows, which impairment losses covers, and a lease discount rate follows its own prescribed order of choices, worked through in lease accounting under the leases standard.
In a valuation engagement it arrives as the discount or capitalization rate. The appraiser selects the appropriate benefit stream, such as pre-tax or after-tax income or cash flows, and selects appropriate discount rates, capitalization rates or multiples consistent with the benefit stream selected within the relevant valuation methodology (Internal Revenue Manual 4.48.4.2.3, Analyzing), which is the step valuation sets out in full.
A client on a contract with full CAS coverage meets a version that is prescribed rather than estimated. Cost of capital committed to facilities means an imputed cost determined by applying a cost of money rate to facilities capital (Cost Accounting Standard 9904.414-30), and that rate is based on rates determined by the Secretary of the Treasury (Cost Accounting Standard 9904.414-40). The rate comes from Treasury rather than from the contractor’s own funding mix, and it governs contract cost measurement rather than the financial statements.
Full coverage is the narrow case. It reaches every standard in part 9904 and applies to a business unit that receives a single CAS-covered award of $50 million or more, or that received $50 million or more in net CAS-covered awards in its preceding cost accounting period (48 CFR 9903.201-2(a)). Modified coverage, which may be applied to a covered contract below that line, reaches only four standards and this is not one of them (48 CFR 9903.201-2(b)), and contracts and subcontracts with small businesses are exempt from the standards altogether (48 CFR 9903.201-1(b)).
What Cost of Capital Is Not
Is Cost of Capital the Same as WACC?
No. WACC is one way of computing an overall cost of capital, the market-value-weighted blend set out above, and it answers for the business as a whole. A project riskier than the business does not take the business’s blend, and the facilities capital rule above reaches its cost of capital without a weighted average at all. Every WACC is a cost of capital. Not every cost of capital is a WACC.
The Cost of Debt Alone
The rate on the loan is one leg of two. Pricing a decision on it treats equity as free, and how much of the balance sheet creditors are funding is a separate reading, held by debt to asset ratio.
The Hurdle Rate
A hurdle rate is the return management requires before it will approve a project. It often starts at the cost of capital and is then raised, for project risk, for capital rationing, or for a margin of safety. One is a fact about what capital providers require, the other is a policy decision layered on top, so they coincide only when a firm chooses to set them equal.
A Capital Asset
Capital here means the funding, not the property. A capital asset in the tax sense is a category the Internal Revenue Code defines by exception, covered in capital assets. Working capital is a third use of the word, held by net working capital. Neither changes what a business has to earn on the money it is funded with.
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