Cost of capital — WACC, CAPM, debt cost

Cost of capital is the discount rate every DCF uses, the hurdle rate every investment decision compares against, and the benchmark every analyst inputs into a valuation. Getting it wrong by 1 percentage point can change a valuation by 20%. CFOs and analysts therefore spend real time on the inputs.

Cost of equity — CAPM

  Re  =  Rf  +  β × ERP

  Re   =  Cost of equity (the return shareholders require)
  Rf   =  Risk-free rate (long-term government bond yield in the company's currency)
  β    =  Beta — sensitivity of the stock's return to the market's return
  ERP  =  Equity risk premium (extra return demanded by equity holders
          over the risk-free rate for taking equity risk)

Example: a Kenyan blue-chip with β = 1.0
  Rf  = 14% (Kenya 10y T-bond)
  ERP = 6% (typical for Kenya)
  Re  = 14% + 1.0 × 6% = 20%

Beta — what it captures

Beta measures the volatility of a stock's returns relative to the broad market. β=1 means the stock moves with the market; β=1.5 means it moves 50% more than the market (more cyclical); β=0.5 means it moves half as much (defensive). For listed companies, beta is computed by regressing stock returns against market returns over 2-5 years. For unlisted companies, analysts use the beta of comparable listed companies (with adjustments for leverage differences).

Cost of debt

Cost of debt is the yield the company would have to pay to issue new debt today. For a listed company with bonds outstanding, observe the bond's yield. For a private company, estimate from comparable issuers or from the rate the bank quotes for new borrowing. Then apply the tax shield: interest is tax-deductible, so after-tax cost is Rd × (1 − tax rate).

Cost of debt: 13% (current bank borrowing rate)
Tax rate: 30%
After-tax cost: 13% × (1 − 0.30) = 9.1%

The tax shield is real value: every $1 of interest paid saves $0.30 in tax.
This is why levered firms have lower cost of capital than unlevered
— up to the point where distress costs offset the tax shield (Module 2).

WACC — weighted-average cost of capital

  WACC  =  (E/V) × Re  +  (D/V) × Rd × (1 − t)

  where  V  =  E + D  (total capital)
         E  =  market value of equity
         D  =  market value of debt
         Re =  cost of equity (CAPM)
         Rd =  cost of debt (pre-tax)
         t  =  effective tax rate

Example:
  Company with 70% equity, 30% debt
  Re = 20%, Rd = 13%, t = 30%
  WACC = 0.70 × 20% + 0.30 × 13% × 0.70
       = 14% + 2.73%
       = 16.73%

The DCF discounts FCFs to firm value (FCFF) at WACC.

Country risk and emerging-market adjustments

For African corporates, an additional 'country risk premium' is often added to the cost of equity to reflect higher political, currency, and institutional risk. Damodaran publishes country risk premia annually — Kenya's is typically 4-6 percentage points above the mature-market baseline. Whether to apply it depends on the methodology and the audience; valuation reports for international investors typically include it explicitly.