Cost of capital

The cost of capital is the rate of return that providers of capital demand to compensate them for both the time value of their money, and risk.

The cost of capital is specific to each particular type of capital a company uses. At the highest level these are the cost of equity and the cost of debt, but each class of shares, each class of debt securities, and each loan will have its own cost.

It is possible to combine these to produce a single number for a companies cost of capital, the WACC.

The cost of capital of a security is used to value securities, as the cost of capital is the appropriate discount rate to apply to the future cash flows that security will pay. For this reason, models that estimate the cost of capital, such as CAPM and arbitrage pricing theory, are regarded as valuation models.

Conversely, the cost of capital of a security can be calculated from the market price and expected future cash flows. This approach makes sense, when, for example, calculating a WACC.

Cost of equity

The cost equity, often referred to as the required rate of return on equity, is most commonly estimated using CAPM. It is also implicitly estimated when using valuation ratios, as differences in the cost of equity is a key component of differences in the ratings at which different companies and sectors trade.

A company may have several classes of shares, in which case each will have its own required rate of return. Their weighted average is the cost of equity.

Cost of debt

The cost of capital of listed debt securities can be estimated in a similar manner to equities. It is also common to compare yield spreads with other similar securities, which roughly corresponds to the use of valuation ratios for equities.

Estimating the cost of capital for unlisted debt is more difficult. It is also an important problem because most companies, including almost all listed companies, have significant amounts of unlisted debt.

One approach is to estimate the cost of the debt by comparing it to the yield on the most similar listed debt. If necessary rates can be adjusted for term and riskiness.

If the debt has been recently issued or is repayable on demand it is reasonable to assume that it is worth close to its book value, and therefore the cost of debt is simply the nominal interest rate. The same applies if the debt pays a floating interest rate and there has been no significant change in its riskiness since it was borrowed.

Cost of hybrid securities

The cost of hybrid securities is a little more complex, and varies with the type of security. For example: