Cost of CapitalCopy Anchor Link

Cost of CapitalCopy Anchor Link

The cost of capital is the discount rate that ties dcf-valuation together — the weighted average of what a business must pay for its debt and equity funding. aswath-damodaran describes it as the single most-used, most-misunderstood number in finance, and his treatment is the primary source here.

One number, many rolesCopy Anchor Link

Damodaran opens his April 2016 paper with the scope of the problem: "There is no number in finance that is used in more places or in more contexts than the cost of capital." Asked what it is, a dozen practitioners will give a dozen answers — hurdle rate, discount rate, financing cost, optimizing tool — and they are all partly right, "and that is the reason the cost of capital is the Swiss Army knife of Finance, much used and oftentimes misused."

The mechanicsCopy Anchor Link

At base it is a weighted average: "The cost of capital, in its most basic form, is a weighted average of the costs of raising funding for an investment or a business, with that funding taking the form of either debt or equity." The cost of equity reflects the risk equity investors perceive; the cost of debt reflects the default risk lenders perceive; the weights reflect the financing mix. The equity-risk-premium is the risk input to the equity leg.

What the number means shifts with who holds it: "For investors in companies, the cost of capital is an opportunity cost in the sense that it is the rate of return that they would expect to make in other investments of equivalent risk." For the company it is a cost of financing; within a multi-business firm it becomes a hurdle rate, potentially different for each business by risk.

As hurdle rate and optimizing toolCopy Anchor Link

In corporate finance the cost of capital is "the benchmark that has to be beaten for an investment to be categorized as a good investment." Two common mistakes: applying one firm-wide cost of capital to investments of differing risk (so safe businesses subsidize risky ones), and computing a project's cost of capital using its own heavy debt load (so levered projects are subsidized by less-levered ones).

On capital structure, it is an optimizing tool: "the mix of debt and equity that minimizes cost of capital is the one that the business should aspire to have, since, in effect, it maximizes the value of the business." This is the valuation-side counterpart to Berkshire's capital-allocation framing of the financing decision.

It is not fixedCopy Anchor Link

The cost of capital is not a constant. In valuation it changes as a firm matures and its risk falls, and it must be re-estimated as fundamentals shift. The Amazon case study in Damodaran's teaching shows the cost of capital declining from over 12% in high-growth years toward 9.6% in the terminal year as beta, leverage, and risk converge on stable-growth norms. The discount-rate idea is the same across the corpus: Damodaran's valuation survey restates it as the practice of using "higher discount rates to discount expected cash flows when valuing riskier assets, and lower discount rates when valuing safer assets." See terminal-value.

For cross-border work the cost of capital must also carry the country risk of the cash flows being discounted — the subject of country-risk-premium. The interaction between the cost of capital and the dcf-valuation discount rate is treated there, and the concept's relationship to intrinsic-value runs through every discounted-cash-flow estimate.

See alsoCopy Anchor Link

• wacc-vs-opportunity-cost
• carried-interest-waterfall — the preferred-return/hurdle-rate form of a discount rate, written into fund LPAs

SourcesCopy Anchor Link

• damodaran/markdown/costofcapital.md
• damodaran/markdown/SFDayOne.md
• damodaran/markdown/valuesurvey.md