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Cost of Capital

3 formulas

Cost-of-capital formulas set the hurdle rate a firm or project must clear. CAPM translates beta and the equity risk premium into a required return on equity; WACC blends that with the after-tax cost of debt in proportion to the capital structure; the equity risk premium is the market-wide input both depend on. These rates are the discount rates used throughout capital budgeting and discounted-cash-flow valuation.

CAPM (Capital Asset Pricing Model)

Cost of equity = risk-free rate + beta × equity risk premium. The most-cited model for translating systematic risk (beta) into a required return on equity.

re=Rf+β×(Rm−Rf)r_e = R_f + \beta \times (R_m - R_f)

WACC (Weighted Average Cost of Capital)

Weighted average of the firm's after-tax cost of debt and cost of equity, weighted by their proportions in the capital structure. The discount rate that pairs with unlevered free cash flow (FCF to firm) in DCF analysis.

WACC=we×re+wd×rd×(1−t)\text{WACC} = w_e \times r_e + w_d \times r_d \times (1 - t)

Equity Risk Premium

Difference between the expected return on the equity market and the risk-free rate. The compensation investors demand for bearing equity (rather than risk-free) risk — the building block of CAPM.

ERP=Rm−Rf\text{ERP} = R_m - R_f