Calculating a Company's Cost of Capital

Prof. Ian H. Giddy, New York University

1. Cost of debt is what it would cost the company, given its rating, in today's market, adjusted for the tax deduction on interest.

Rd = Interest Rate(1-Tax Rate)
     = (Riskfree Rate + Credit Spread)(1-Tax Rate)

The Credit Spread is a function of the individual company's credit risk, and the market price of credit risk.

2. Cost of equity, based on the Capital Asset Pricing Model (CAPM) is the required return on common stock if the company were to go to the market today, taking into account its business risk and leverage risk. The CAPM formula, which assumes that investors are well diversified, is:

ie Return on Equity= Riskfree Rate + Levered Beta(Market Return - Riskfree Rate)

We start with the company's current (levered) beta, then obtain the unlevered beta, then see what the beta would be at different levels of leverage:

The current unlevered beta is Betaunlev=Betalev/(1+(1-tax rate)(D/E)) =
Current debt/equity (D/E) ratio = total debt/(share price*shares outstanding)
The levered beta is found from: Betalev=Betaunlev(1+(1-tax rate)(D/E)
The Riskfree rate is a long-term government bond rate, such as the 10-year Treasury yield. The Market Return is the expected long term performance of a broad market portfolio, such as the S&P 500.

3. Weighted Average Cost of Capital is:

WACC = Rd(D/C ratio)+Re(E/C ratio)

Debt/capital (D/C) ratio = total debt/(total debt +share price*shares outstanding)
Equity/capital (E/C) ratio = total equity/(total debt +share price*shares outstanding)

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