Cost of Capital: Cost of Debt and Cost of Equity

Every company finances itself from two core sources: debt (loans and bonds) and equity (shareholder capital). Each source has a “cost” — the return its provider expects in exchange for their money.

Cost of Debt

Simpler than cost of equity — usually the interest rate a company pays on its borrowings. But there’s an important twist: interest expense is tax-deductible, meaning debt provides a “tax shield.” So we calculate cost of debt after tax:

After-Tax Cost of Debt = Interest Rate × (1 − Tax Rate)

Example: if the interest rate is 9% and the tax rate is 22.5%:

After-Tax Cost of Debt = 9% × (1 − 0.225) = 6.975%

Cost of Equity — the CAPM model

Shareholders don’t hand over their money for free — they expect a return that compensates them for the risk they’re taking (which is higher than a lender’s risk, since they’re last in line if the company is liquidated). The most common model for estimating this return is CAPM:

Cost of Equity = Risk-Free Rate + Beta × Equity Risk Premium
Re = Rf + β × (Rm − Rf)

• Risk-Free Rate: typically the yield on long-term government bonds.
• Beta: measures how sensitive a company’s stock is to overall market movements. A beta of 1 means the stock moves exactly with the market; above 1 means higher volatility (higher risk) than the market.
• Equity Risk Premium: the extra return investors demand for investing in stocks instead of risk-free assets.

Example: Rf = 4%, β = 1.2, equity risk premium = 6.5%:

Re = 4% + 1.2 × 6.5% = 11.8%

Notice that cost of equity (11.8%) is higher than the after-tax cost of debt (6.975%) — which makes sense, since shareholder risk is higher than lender risk.

Now that we understand the “cost” of each financing source, it’s time to dig into the actual types and sources of that financing — starting with equity.