Valuation

Cost of Equity and WACC: CAPM, Size and Specific Risk

The cost of capital is the return investors require to fund a business. Cost of equity is typically estimated with CAPM, the risk-free rate plus beta times the equity risk premium, or with a build-up that adds size and company-specific premia. WACC blends the cost of equity and after-tax cost of debt at target market value weights.

What is the cost of capital?

The cost of capital is the minimum return a business must earn on its investments to satisfy the people who fund it. It is an opportunity cost: investors could place their money in other assets of similar risk, so they require at least that alternative return. In valuation the cost of capital serves as the discount rate that converts future cash flows into present value, and in corporate finance it is the hurdle rate new projects must clear. Choosing that rate is therefore one of the most consequential judgments in any valuation.

Different capital providers face different risks and therefore require different returns. Lenders have contractual claims and priority in default, so their required return is lower. Equity holders are residual claimants who absorb losses first, so they require more. The weighted average cost of capital combines the two in proportion to how the business is financed, producing the rate appropriate for discounting cash flows available to all capital providers. Because WACC depends on the mix of debt and equity, it changes when the capital structure changes. That is why a valuation should use a sustainable target structure rather than whatever the balance sheet shows at a single date, and why a highly leveraged acquisition structure should not automatically lower the discount rate applied to the business.

How is cost of equity estimated with CAPM?

The capital asset pricing model holds that investors are compensated only for systematic risk, the portion of volatility that cannot be diversified away. Cost of equity equals the risk-free rate plus beta multiplied by the equity risk premium. The risk-free rate is usually a government bond yield with a maturity matched to the cash flow horizon. Beta measures how sensitive a stock's returns are to market returns. The equity risk premium is the expected excess return of the broad equity market over the risk-free rate.

For private companies, beta cannot be observed directly. Practitioners take levered betas of public peers, remove the effect of each peer's leverage to obtain an asset beta, average those, and relever at the subject's target capital structure. This adjusts for the fact that more debt makes equity riskier. Each input involves judgment, and the sources and dates for the risk-free rate and equity risk premium should be documented and applied consistently. Peer betas should be measured over a consistent period and return frequency, and outliers caused by thin trading or unusual events should be excluded or explained.

When are size and company-specific risk premia used?

In valuing smaller private businesses, many practitioners add premia that CAPM does not capture. A size premium reflects the observation that smaller companies have historically earned returns beyond what their betas would predict, and it is often sourced from published studies of returns by market capitalization. A company-specific risk premium addresses factors unique to the subject: customer concentration, key-person dependence, thin management depth, limited access to capital or a volatile earnings history. The two premia are often combined in a build-up model that starts from the risk-free rate and adds layers of required return for equity risk, size and specific factors.

Both premia are contested. Some argue size effects are unstable over time, and company-specific premia are inherently subjective. The defensible approach is to tie each premium to identifiable risk factors, avoid double counting risks already reflected in the cash flow forecast, and test the resulting discount rate against the returns that buyers of similar private businesses actually seek. A specific risk premium chosen to reconcile to a target value is a red flag. Underwriters should also confirm that the resulting cost of equity is consistent with the multiple implied by the valuation; an unusually high rate paired with an unusually high multiple usually signals an inconsistency.

How is the cost of debt determined?

The cost of debt is the yield the company would pay on new borrowing today, not the coupon on legacy loans. For companies with traded debt, the yield to maturity provides a market estimate. For private companies, it can be inferred from current pricing on comparable loans given the borrower's leverage and credit profile, or from a synthetic credit rating based on interest coverage. Because interest is generally tax deductible, the after-tax cost of debt is used in WACC. Credit spreads can change quickly, so the date of the market evidence matters.

Underwriters should be alert to interest deductibility limits, which can cap the tax shield for highly leveraged companies, and to the fact that a business with losses may not benefit from the shield at all. The marginal tax rate used should reflect the rate at which deductions actually reduce cash taxes. For highly leveraged borrowers, the promised yield on debt also overstates the expected return to lenders, because some probability of default is embedded in the spread. In most valuations the difference is ignored, but for distressed businesses it can be material. Floating-rate debt also introduces a forward rate question: the cost should reflect expected rates over the horizon, not only today's spot rate.

How do you calculate WACC?

WACC weights the cost of each capital source by its proportion of total capital, measured at market values rather than book values. Book equity reflects historical contributions and retained earnings, not what investors would pay today, so it understates or overstates the true weight. For private companies or acquisitions, a target or industry-typical capital structure is usually used, since the current structure may be temporary or the valuation itself determines equity value. When the purchase price determines the equity weight, iterate until the assumed weights are consistent with the resulting values.

Preferred equity and other hybrid instruments receive their own weight and cost if material. The resulting WACC should be sanity checked against the risk of the business: a stable utility-like company and an early-stage software firm should not end up with similar rates. If they do, one or more inputs is likely misapplied. It is also good practice to compare the calculated WACC with the expected returns implied by recent transaction multiples for similar businesses. A large gap may indicate that the market is pricing risk differently, or that an input such as the size premium is overstated. Documenting this comparison strengthens the conclusion and helps reviewers understand which judgments drive the result.

Building up a WACC for a private manufacturer

1. Inputs: risk-free rate 4.0%, relevered beta 1.2, equity risk premium 5.5%, size premium 2.0%, company-specific premium 3.0%.
2. CAPM cost of equity = 4.0% + 1.2 x 5.5% = 4.0% + 6.6% = 10.6%.
3. Adjusted cost of equity = 10.6% + 2.0% + 3.0% = 15.6%.
4. Pre-tax cost of debt = 8.0%, tax rate 25%: after-tax cost of debt = 8.0% x 0.75 = 6.0%.
5. Target capital structure: 30% debt, 70% equity.
6. WACC = 0.70 x 15.6% + 0.30 x 6.0% = 10.92% + 1.80% = 12.72%.
7. Sensitivity: removing the 3.0% specific premium lowers cost of equity to 12.6% and WACC to 0.70 x 12.6% + 1.80% = 10.62%, showing how much one judgment input moves the rate.

How underwriters apply this

• Require written support for every premium in a build-up and check that the same risk is not also haircut in the forecast.
• Use market or target capital weights, not book values, and confirm the debt weight is consistent with the proposed financing.
• Price the cost of debt at current market terms for a borrower of this credit quality, not at historical coupons.
• Show a sensitivity of value to WACC so the committee sees the effect of a one-point change in the rate.
• Compare the implied return expectations with returns buyers are seeking in similar private transactions as a reasonableness test.

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Educational content written by practitioners. Not investment, accounting, legal or tax advice.