How do you calculate cost of debt vs. cost of equity?

Q: How do you calculate cost of equity using CAPM?

The CAPM formula is: Cost of Equity = Risk-Free Rate + Beta x Equity Risk Premium. The risk-free rate is typically the 10-year or 20-year government bond yield. Beta measures the stock's sensitivity to market returns. The equity risk premium (typically 5-7% for U.S. markets) represents the expected return above the risk-free rate for bearing equity market risk.

Q: How do you calculate the cost of debt?

The primary method uses yield to maturity (YTM) on the company's traded bonds, reflecting current market pricing of credit risk. Alternatively, use the credit spread method: Risk-Free Rate + Credit Spread based on the company's rating (e.g., BBB-rated debt typically carries 150-250 bps over Treasuries). Always apply the tax shield: After-Tax Cost = Pre-Tax Cost x (1 - Tax Rate).

Q: What is beta and how do you unlever and relever it?

Beta measures a stock's systematic risk relative to the market. Raw betas reflect the company's current leverage. To compare across companies, unlever beta to remove capital structure effects using the Hamada equation, then relever at the target company's capital structure. This ensures the beta used in CAPM reflects the appropriate level of financial risk.

Q: Why is cost of equity higher than cost of debt?

Equity holders bear residual risk—they're paid last in bankruptcy and have no contractual right to returns. Debt holders have priority claims and contractual interest payments. Because equity investors take on more risk, they demand higher returns to compensate. Additionally, interest on debt is tax-deductible, further reducing debt's effective cost relative to equity.

Master cost of capital for IB interviews: WACC formula, component calculations, and the logic behind hurdle rates.

OfferGoblin·4 min read··

"The cost of capital is the rate of return that capital could be expected to earn in the best alternative investment of equivalent risk." — Tim Koller, Valuation: Measuring and Managing the Value of Companies

Concept

Cost of capital refers to the required returns for each financing source—debt and equity—calculated independently before any blending. Understanding how to derive each component is foundational: cost of debt reflects contractual obligations to lenders, while cost of equity captures the return shareholders demand for bearing residual risk. Each requires distinct methodologies and adjustments.

Intuition

Why components matter independently:

Cost of debt is observable from markets—bond yields or credit spreads give direct readings.
Cost of equity is unobservable and must be estimated, typically via CAPM plus adjustments for company-specific risks.
Each component has its own drivers: debt costs move with credit quality and rates; equity costs move with market risk, company size, and geographic exposure.
Mastering each component separately ensures accurate inputs regardless of how they're ultimately combined.

Components

Cost of Debt

The return creditors require to lend to the company.

Primary Method: Yield to Maturity (YTM) Use YTM on the company's existing traded bonds—this reflects current market pricing of credit risk.

Alternative: Credit Spread Method

r_{d} = r_{f} + Credit Spread

Add a spread based on credit rating to the risk-free rate. BBB-rated debt typically carries 150-250 bps over Treasuries.

Tax Shield Adjustment Interest is tax-deductible, reducing the effective cost:

r_{d}^{after-tax} = r_{d} \times (1 - T)

Use marginal tax rate. If the company has NOLs or doesn't pay taxes, the tax shield has no value—use pre-tax cost.

Cost of Equity via CAPM

The return equity holders require for bearing residual risk. Estimated via the Capital Asset Pricing Model:

r_{e} = r_{f} + β \times ERP

Components:

$r_{f}$ = Risk-free rate, typically 10-year or 20-year government bond yield matching cash flow duration
$β$ = Systematic risk measure; sensitivity of stock returns to market returns
$ERP$ = Equity risk premium; expected market return above risk-free rate (typically 5%-7% for U.S. markets)

Key Point: CAPM captures only systematic (non-diversifiable) risk. Company-specific risks require additional premium adjustments.

Beta Adjustments

Raw betas reflect a company's current capital structure. To compare across firms or apply to a target, unlever and relever.

Unlevering (remove target's leverage):

β_{U} = \frac{β _{L}}{1 + ( 1 - T ) \times \frac{D}{E}}

Relevering (apply new capital structure):

β_{L} = β_{U} \times [1 + (1 - T) \times \frac{D}{E}]

Application:

Gather betas from comparable companies
Unlever each to remove their capital structure effects
Take median unlevered beta
Relever to target company's capital structure

This isolates business risk from financial risk.

Additional Premiums

CAPM alone may understate required returns. Common adjustments:

Size Premium (Small Stock Premium) Smaller companies historically earn returns above CAPM predictions. Add 1%-5% depending on market cap decile. Source: Duff & Phelps/Kroll data.

Country Risk Premium (CRP) For companies with emerging market exposure:

r_{e} = r_{f} + β \times ERP + CRP

Estimate CRP via sovereign default spreads or relative equity volatility. Apply based on revenue/asset exposure, not just domicile.

Company-Specific Risk Premium Rarely used in public company valuations but common in private company analysis for idiosyncratic risks (customer concentration, key-man risk). Highly judgmental—typically 1%-5%.

Interview Script

Cost of capital is the required return that investors demand for providing financing to a company, calculated separately for each source of funding. Cost of debt is observable from market yields and reflects contractual obligations to lenders, while cost of equity must be estimated—typically using CAPM—because it represents the return shareholders require for bearing residual business risk. These components have different drivers: debt costs depend on credit quality and interest rates, while equity costs are driven by market risk, company size, and other firm-specific factors.

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Frequently Asked Questions

How do you calculate cost of equity using CAPM?

How do you calculate the cost of debt?

What is beta and how do you unlever and relever it?

Why is cost of equity higher than cost of debt?