How can you calculate a company's cost of capital?

2 Calculate the weighted average cost of capital

The second step is to calculate the weighted average cost of capital (WACC), which is the overall cost of capital for the company. The WACC is the sum of the products of the cost and weight of each source of capital. The cost of equity can be estimated using the capital asset pricing model (CAPM), which considers the risk-free rate, the market risk premium, and the beta of the company. The cost of debt can be approximated by the interest rate on the company's bonds or loans, adjusted for the tax shield. The cost of preferred stock and other securities can be derived from their dividend or coupon payments and market prices.

3 Use the WACC as a discount rate

The third step is to use the WACC as a discount rate to evaluate the company's investments and projects. The WACC represents the minimum return that the company should accept for any project, as it reflects the opportunity cost of capital. By comparing the net present value (NPV) or internal rate of return (IRR) of a project with the WACC, you can determine whether the project adds value to the company or not. The WACC can also be used to estimate the value of the company by discounting its expected future cash flows.

4 Adjust the WACC for different risks

The fourth step is to adjust the WACC for different risks that may affect the company's projects or divisions. The WACC is based on the average risk and capital structure of the company, but some projects or divisions may have higher or lower risks than the average. To account for this, you can use the pure play method, which involves finding a comparable company or project with a similar risk profile and using its beta or cost of capital as a proxy. Alternatively, you can use the subjective method, which involves adding or subtracting a risk premium or discount to the WACC based on your judgment.

5 Review and update the WACC periodically

The fifth step is to review and update the WACC periodically, as the cost and weight of each source of capital may change over time due to market conditions, financial decisions, or business performance. The WACC is not a static or fixed number, but a dynamic and flexible one that reflects the current situation and expectations of the company and its financiers. By updating the WACC regularly, you can ensure that you are using the most accurate and relevant discount rate for your valuation and decision-making.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?