By the end of this lesson you know what a company's cost of debt is and why the cost that really matters is the after-tax cost.
\nROIC and DCF, already covered in earlier modules, used cost of capital as a general figure -- the minimum return a company should generate to justify the capital it has invested. This module starts pinning down that figure, component by component. The first is cost of debt.
\nCost of debt is the effective interest rate a company pays on its financial debt -- the same financial debt that, already covered when calculating invested capital in Level 2, is distinguished from total liabilities: it doesn't include what's owed to suppliers or other items with no explicit financial cost, only debt that actually generates interest.
\nBut the interest rate the company pays isn't, on its own, the real cost it bears. Interest on debt is tax-deductible: it reduces the income taxes are calculated on, so part of that interest is indirectly "paid" by the tax authorities, not the company. This is called the tax shield of debt. The cost of debt that really matters for valuing a company is the after-tax cost: the interest rate the company pays, multiplied by one minus its applicable tax rate.
\nFor this reason -- and because lenders have priority of repayment over shareholders if the company runs into trouble, which makes debt less risky for whoever provides it -- the cost of debt is generally lower than the cost of equity, covered in the next lesson.
\nA company pays 5% annual interest on its financial debt. If its applicable tax rate is 25%, the after-tax cost of debt is 5% × (1 − 0.25) = 3.75% -- more than a percentage point below the nominal interest rate, precisely because of the tax shield.
\nCost of debt is the effective interest rate a company pays on its financial debt, adjusted for the tax shield on interest -- the after-tax cost, not the nominal rate. It's usually lower than the cost of equity because debt is less risky for whoever provides it.
\nWhy is the relevant cost of debt the after-tax cost and not the nominal interest rate?
\nWhy is the cost of debt calculated on financial debt and not on total liabilities?
","sortOrder":1,"readingMinutes":7,"difficulty":"Intermedio"},"previous":null,"next":{"id":62,"moduleId":22,"slug":"what-is-the-cost-of-equity-and-how-is-it-estimated-with-capm","title":"What is the cost of equity and how is it estimated with CAPM?","summary":"You know what the cost of equity is, why it isn't the same as equity itself, and how it's estimated with CAPM.","bodyMarkdown":"## Objectives\n\nBy the end of this lesson you know what the cost of equity is, why it isn't the same as equity itself, and how it's estimated with CAPM.\n\n## Content\n\nThe second component of cost of capital is cost of equity: the minimum return a company's shareholders demand for taking on the risk of investing in it. It's easy to confuse it with equity, already covered in Level 2 -- both names mention \"equity\" -- but they're magnitudes of a completely different nature. Equity is a book value: a balance sheet figure, what's left of assets after subtracting liabilities. Cost of equity is a required rate of return: a percentage, not a monetary figure. They aren't the same magnitude under a different name.\n\nThe most widely used model for estimating cost of equity is CAPM (Capital Asset Pricing Model). CAPM isn't a magnitude in itself -- it's the method used to estimate this rate, just as the accrual basis is the method used to build the income statement. It starts from three elements. The first is the risk-free rate: the return on a virtually risk-free investment, like a solvent country's long-term government debt. The second is the market risk premium: the extra return investors demand for investing in equities instead of that risk-free asset, precisely to compensate for the risk -- the uncertainty about the future outcome, already covered in Level 1 -- they take on by doing so. The third is the stock's beta: a measure of how much that specific stock's returns move relative to the market as a whole -- a beta above one indicates the stock amplifies market movements, and a company with a beta like that rightly demands a higher risk premium.\n\nCAPM combines these three elements: cost of equity is the risk-free rate plus the market risk premium, adjusted by the stock's beta. But the result isn't an exact, unquestionable figure -- it depends on which risk-free rate, which risk-premium period, and which beta estimate are used. Two reasonable analysts can arrive at different estimates of the same company's cost of equity, without either necessarily being wrong.\n\nThe next lesson combines the cost of debt and the cost of equity, weighted by their relative share in the company's financing, to obtain the WACC.\n\n## Example\n\nIf the risk-free rate is 3%, the market risk premium is 5%, and a stock's beta is 1.2, the cost of equity estimated with CAPM is 3% + 1.2 × 5% = 9%. With a beta of 0.8, that same calculation would give 3% + 0.8 × 5% = 7% -- the same company, a different cost of equity, just from having a different sensitivity to the market.\n\n## Common mistakes\n\n- Confusing cost of equity with equity itself because of the similar names -- one is a required rate of return, the other is a balance sheet book figure.\n- Treating the CAPM result as an exact, definitive figure, without accounting for the fact that it depends directly on the risk-free rate, risk premium, and beta estimates used.\n\n## Summary\n\nCost of equity is the minimum return a company's shareholders demand, not a book figure -- it shouldn't be confused with equity. CAPM is the most widely used model for estimating it: risk-free rate plus market risk premium, adjusted by the stock's beta. The result is a reasoned estimate, sensitive to its assumptions, not an unquestionable figure.\n\n## Self-check\n\nWhy isn't cost of equity the same as equity, despite the similar names?\n\nWhat three elements does CAPM combine to estimate cost of equity, and why isn't the result an exact figure?","bodyHtml":"By the end of this lesson you know what the cost of equity is, why it isn't the same as equity itself, and how it's estimated with CAPM.
\nThe second component of cost of capital is cost of equity: the minimum return a company's shareholders demand for taking on the risk of investing in it. It's easy to confuse it with equity, already covered in Level 2 -- both names mention "equity" -- but they're magnitudes of a completely different nature. Equity is a book value: a balance sheet figure, what's left of assets after subtracting liabilities. Cost of equity is a required rate of return: a percentage, not a monetary figure. They aren't the same magnitude under a different name.
\nThe most widely used model for estimating cost of equity is CAPM (Capital Asset Pricing Model). CAPM isn't a magnitude in itself -- it's the method used to estimate this rate, just as the accrual basis is the method used to build the income statement. It starts from three elements. The first is the risk-free rate: the return on a virtually risk-free investment, like a solvent country's long-term government debt. The second is the market risk premium: the extra return investors demand for investing in equities instead of that risk-free asset, precisely to compensate for the risk -- the uncertainty about the future outcome, already covered in Level 1 -- they take on by doing so. The third is the stock's beta: a measure of how much that specific stock's returns move relative to the market as a whole -- a beta above one indicates the stock amplifies market movements, and a company with a beta like that rightly demands a higher risk premium.
\nCAPM combines these three elements: cost of equity is the risk-free rate plus the market risk premium, adjusted by the stock's beta. But the result isn't an exact, unquestionable figure -- it depends on which risk-free rate, which risk-premium period, and which beta estimate are used. Two reasonable analysts can arrive at different estimates of the same company's cost of equity, without either necessarily being wrong.
\nThe next lesson combines the cost of debt and the cost of equity, weighted by their relative share in the company's financing, to obtain the WACC.
\nIf the risk-free rate is 3%, the market risk premium is 5%, and a stock's beta is 1.2, the cost of equity estimated with CAPM is 3% + 1.2 × 5% = 9%. With a beta of 0.8, that same calculation would give 3% + 0.8 × 5% = 7% -- the same company, a different cost of equity, just from having a different sensitivity to the market.
\nCost of equity is the minimum return a company's shareholders demand, not a book figure -- it shouldn't be confused with equity. CAPM is the most widely used model for estimating it: risk-free rate plus market risk premium, adjusted by the stock's beta. The result is a reasoned estimate, sensitive to its assumptions, not an unquestionable figure.
\nWhy isn't cost of equity the same as equity, despite the similar names?
\nWhat three elements does CAPM combine to estimate cost of equity, and why isn't the result an exact figure?
","sortOrder":2,"readingMinutes":9,"difficulty":"Intermedio"},"pathContext":null,"curatedLinks":{"prerequisite":[],"continuation":[],"related":[]},"relatedConcepts":[{"concept":{"id":74,"slug":"cost-of-debt","term":"Cost of debt","shortDefinition":"The effective interest rate a company pays on its financial debt, adjusted for the tax benefit of interest.","longDefinition":"Cost of debt is the effective interest rate a company pays on its financial debt -- the same financial debt, already distinguished from total liabilities, that's part of invested capital, already covered in Level 2. It isn't simply the nominal interest rate: because interest on debt is tax-deductible, the real cost the company bears is lower than the rate it pays -- the so-called \"tax shield\" of debt. That's why the cost of debt relevant to the WACC is the after-tax cost: the interest rate multiplied by (1 minus the tax rate). It's generally lower than the cost of equity, because debt is less risky for whoever provides it -- it has priority of repayment over shareholders if the company runs into trouble."}}]}