What is the Cost of Capital?

Posted in CFA by qmarks on February 1, 2010

A firm’s cost of capital is the minimum rate a return the firm should expect to earn on its invested funds so that all providers of funds just earn their required rate of return.

Thus the cost of capital is a Weighted Average Cost of Capital – WACC

WACC = Return on Debt x Debt / ( Debt + Equity ) + Return on Equity x Equity / ( Debt + Equity)

How do you find Return on Debt?

One can easily check the 10-K and find the cost of borrowing. But since we will use WACC for Discounted Cash Flow calculations it has to be forward looking. One way to find the cost of debt is find the risk free rate for the period we are forecasting such as 10 year bond, and add the risk spread by the credit quality of the firm.

The return on equity is calculated by the CAPM.

Return on Equity = Risk Free Rate + Beta x Risk Premium.

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