FINM3005 · Corporate Valuation
Cost of Capital
The discount rate is where most valuations quietly go astray: a beautifully forecast cash flow discounts to the wrong number if the WACC is wrong. This chapter builds the weighted-average cost of capital from the ground up — the blended required return of all capital providers at the firm's target, market-value capital structure: WACC = (E/V)·Rₑ + (D/V)·Rₐ·(1−T). Because free cash flow to the firm is cash to all investors, the discount rate must be the return required by all investors; that consistency is the whole point. You estimate the cost of equity with the CAPM and the security market line (Rₑ = R₆ + β(Rₘ − R₆)), pin down the risk-free rate (a long-term government bond) and the market risk premium (Australian historical ~6%, implied ~8%), and — the centrepiece — estimate beta by the unlever–relever two-step from peer betas, since an equity beta is contaminated by each peer's leverage. The cost of debt comes from the credit spread (rating or interest-coverage), made after-tax by the (1−T) shield. The recurring traps the exam probes hardest: book weights, averaging levered betas, and using the current rather than the target structure.
What this chapter covers
- 01WACC: the blended hurdle rate and the four consistency principles
- 02Cost of equity via the CAPM and the security market line
- 03Pinning the inputs: risk-free rate, market risk premium, beta
- 04Beta: the unlever–relever two-step from peer betas
- 05Cost of debt from the credit spread, made after-tax
- 06Setting the weights: market value, at the target structure
- 07The levered cost-of-equity identity and the trap list
Worked example: peer betas to WACC
- +1Unlever each peer with βₐ = βₑ / [1 + (1−T)·D/E]: 1.10 / 1.28 = 0.86; 1.30 / 1.49 = 0.87; 0.95 / 1.175 = 0.81.
- +1Average asset beta = (0.86 + 0.87 + 0.81) / 3 ≈ 0.85 — the shared risk of the business.
- +1Relever to the firm's target D/E = 0.667: βₑ = 0.85 × [1 + 0.7×0.667] = 0.85 × 1.467 ≈ 1.05.
- +1Cost of equity (CAPM): Rₑ = 4.0% + 1.05(6.0%) = 10.3%.
- +1After-tax cost of debt: Rₐ = 4.0% + 1.6% = 5.6%; after-tax = 5.6%(1 − 0.30) = 3.9%.
- +1Blend at market-value target weights: WACC = 0.60(10.3%) + 0.40(3.9%) = 6.18% + 1.56% ≈ 7.8%.
Key terms
- WACC
- Weighted-average cost of capital = (E/V)·Rₑ + (D/V)·Rₐ·(1−T) — the blended required return of all capital providers, used to discount free cash flow to the firm. Weights are market-value and set at the firm's target structure; for an all-equity firm WACC = the cost of equity.
- CAPM / security market line
- The capital asset pricing model: required equity return Rₑ = R₆ + β(Rₘ − R₆), rising linearly with systematic risk. Plotted against beta it is the security market line, starting at the risk-free rate, passing through the market portfolio at β = 1, with slope equal to the market risk premium.
- Beta (asset vs equity)
- The sensitivity of returns to the market. The equity beta is contaminated by leverage, so peers are unlevered to a shared asset (business) beta, which is averaged and then relevered to the subject firm's own target D/E. The asset beta is the risk of the operations themselves; equal asset betas still give different equity betas because firms carry different debt.
- Market risk premium (MRP)
- The expected excess return of the market over the risk-free rate — the slope of the security market line. Estimated from history (Australian ~6%) or implied from current prices (~8% post-COVID). A prime sensitivity candidate; state which you use and why, and match its duration to a long-term risk-free rate.
- After-tax cost of debt
- Rₐ(1−T), where Rₐ = risk-free rate + a default spread read from the credit rating or the interest-coverage ratio. The (1−T) is the interest tax shield that makes debt cheaper than its headline rate; it belongs in the WACC, not in the operating cash flow.
Cost of Capital FAQ
Why must I use market-value, not book, weights?
Book equity is a historical accounting residual; the market value of equity is what shareholders actually have at stake. For a healthy firm book equity is below market equity, so book weights overstate the debt weight and drag the WACC the wrong way. Use market-value equity and net debt at market value (including leases and pension, less excess cash). Book weights are the single most common WACC error.
Why unlever and relever beta — can't I just average the peers' betas?
No. An equity beta reflects both the business risk and each peer's leverage, and more debt magnifies equity risk. Averaging raw equity betas mixes in different leverage and is meaningless. You unlever each peer to its underlying asset beta (the risk of the operations, shared across the industry), average those, then relever to your firm's target D/E. Forgetting either step is the signature beta mistake.
Should I use the firm's current capital structure or its target?
Use the target structure, not whatever this year's balance sheet happens to show — unless current leverage is already at target. A stable target ratio gives a constant WACC, so the enterprise DCF absorbs financing without forecasting it year by year. A transient, off-target current structure feeds a WACC the firm will not actually operate at, and an unstable, circular discount rate.
Historical or implied market risk premium?
Both are defensible; state which and why. The historical MRP (Australian ~6%) is a backward-looking average of realised excess returns. The implied MRP (~8% post-COVID) is forward-looking, backed out of current prices and expected growth, and depends on a market-efficiency assumption. Whichever you pick, the MRP is a prime sensitivity input — flag it and test the value's response.
Exam move
Build the WACC in a fixed order you can reproduce under exam pressure: unlever peer betas → average the asset beta → relever to your target D/E → CAPM cost of equity → after-tax cost of debt → blend at market-value target weights. Memorise the four consistency principles (covers all investors, same currency/nominal basis as the cash flow, stable target structure, no single 'correct' model) and finish every WACC with a sanity check that ROIC sits above it. Keep the three signature traps on a sticky note: book weights instead of market, averaging levered betas without unlevering, and current instead of target structure. Always flag the MRP and beta as the fragile inputs for sensitivity analysis — that is exactly where the markers probe.
