Summary WACC & Cost of Capital Explained - Complete Mini-Guide

WACC & COST OF CAPITAL EXPLAINED

FINN1011 Finance | Complete Mini-Guide


1. What is Cost of Capital?
Cost of capital is the minimum return investors require to provide financing to a company.


Why It Matters:
• Used as the discount rate for NPV calculations
• Hurdle rate for investment decisions
• Measures the "opportunity cost" of using funds




2. Components of Cost of Capital

Source Cost Why?


Equity (Re) Higher Shareholders bear most risk (paid last)


Debt (Rd) Lower Creditors have priority + tax shield




3. Cost of Equity (Re)
Two methods to calculate cost of equity:



Method 1: CAPM


Re = Rf + β × (Rm - Rf)


Risk-free rate + Beta × Market Risk Premium




Method 2: Dividend Discount Model (DDM)


Re = (D₁ / P₀) + g


Dividend Yield + Growth Rate




CAPM Example:
Rf = 4%, Rm = 10%, β = 1.2
Re = 4% + 1.2 × (10% - 4%) = 4% + 7.2% = 11.2%




4. Cost of Debt (Rd)

Key Point: Debt is TAX-DEDUCTIBLE!


Interest payments reduce taxable income, creating a "tax shield."




After-Tax Cost of Debt:


Rd (after-tax) = Rd × (1 - Tc)


Pre-tax cost of debt × (1 - Tax rate)




Example: