Technical / Capital
Cost of Capital
Master cost of capital for IB interviews: WACC formula, component calculations, and the logic behind hurdle rates.
"The cost of capital is the rate of return that capital could be expected to earn in the best alternative investment of equivalent risk." — Tim Koller, Valuation: Measuring and Managing the Value of Companies
Concept
Cost of capital refers to the required returns for each financing source—debt and equity—calculated independently before any blending. Understanding how to derive each component is foundational: cost of debt reflects contractual obligations to lenders, while cost of equity captures the return shareholders demand for bearing residual risk. Each requires distinct methodologies and adjustments.
Intuition
Why components matter independently:
- Cost of debt is observable from markets—bond yields or credit spreads give direct readings.
- Cost of equity is unobservable and must be estimated, typically via CAPM plus adjustments for company-specific risks.
- Each component has its own drivers: debt costs move with credit quality and rates; equity costs move with market risk, company size, and geographic exposure.
- Mastering each component separately ensures accurate inputs regardless of how they're ultimately combined.
Components
Cost of Debt
The return creditors require to lend to the company.
Primary Method: Yield to Maturity (YTM) Use YTM on the company's existing traded bonds—this reflects current market pricing of credit risk.
Alternative: Credit Spread Method
Interview Script
Cost of capital is the required return that investors demand for providing financing to a company, calculated separately for each source of funding. Cost of debt is observable from market yields and reflects contractual obligations to lenders, while cost of equity must be estimated—typically using CAPM—because it represents the return shareholders require for bearing residual business risk. These components have different drivers: debt costs depend on credit quality and interest rates, while equity costs are driven by market risk, company size, and other firm-specific factors.