The calculation of company´s cost of capital

• Cost of debt = risk-free rate + company risk premium
• Cost of equity (risk-free rate + about 6% equity risk premium)
  • The equity risk premium is adjusted with the company´s risk level
  • The risk level of a company depends on the business risk (business field) and on the financial risk (solvency)
• A company´s cost of capital is calculated as a weighted average of the above costs of equity and debt.
  • The cost of capital is calculated with the target solvency ratio (The cost of capital can not be decreased simply by increasing leverage since increasing leverage increases the risk (and cost) of both equity and debt.)
  • Debt cost includes tax shield (1-tax rate) since interest on debt can be deducted from the taxable revenues
• EXAMPLE:
  • Cost of debt: 5,2% + 1% = 6,2% (in the long run)
  • Cost of equity: 5,2% + 1,2 * 6% = 12,5%
  • Weighted average cost of capital (WACC): 6,2% * 55% * (1-tax rate) + 12,5% * 45% = 9%