Cost of Capital

The widely accepted and used method of calculating cost of capital is the Weighted Average Cost of Capital (WACC) which takes in to account the cost of debt and cost of equity by applying a weighting to each, based on the gearing of the entity.

The formula for WACC is :

WACC = (i(1-t) x (d/d+e)) + (Ke x (e/d+e))

i = interest rate on debt
t = tax rate
d = debt value
e = equity value
Ke = cost of equity

The cost of equity can be calculated using a Capital Asset Pricing Model (CAPM), which is a wide recognised model that takes market risk into account.

The formula for CAPM is:

CAPM = Ke = Rf + b(Rm – Rf) + Scp

Rf = risk free rate of return
Rm = Return on market
b = beta for the stock or comparable stock (correlation of share price to market)
Scp = small company premium (added for small sized entity WACC)

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