Cost of Capital

Every dollar a company raises has a price. Lenders charge interest; equity investors demand returns for taking on risk. The cost of capital blends those prices into a single hurdle rate. It does two jobs. First, it's the benchmark for investment decisions — a company should only pursue projects whose return on invested capital exceeds its cost of capital, otherwise it's destroying shareholder value. Second, it's the engine of valuation: in a DCF, you discount projected free cash flows at the cost of capital to get present value. A higher cost of capital means future cash is worth less today, so valuations fall — which is why even a 0.5% change in WACC can swing a DCF by 10%+.

Don't confuse the three. Cost of debt is the after-tax interest rate on borrowings — cheap, because interest is tax-deductible and lenders sit ahead of equity in the capital stack. Cost of equity is the return shareholders demand, usually estimated via CAPM; it's always higher than cost of debt because equity holders are last in line and bear the most risk. WACC is the weighted blend of the two. When you value the whole firm (unlevered free cash flow → enterprise value), you discount at WACC. When you value only the equity (levered free cash flow → equity value), you discount at the cost of equity alone.

Because debt is cheaper than equity, adding debt initially lowers WACC and the tax shield adds value — this is the core logic behind a leveraged buyout. But it's not free leverage forever: as debt rises, both lenders and equity holders perceive more bankruptcy risk, so cost of debt and cost of equity both climb. WACC follows a U-shape, hitting a minimum at the 'optimal' capital structure before rising again. This is why a heavily levered company doesn't automatically have a lower cost of capital — beyond a point, financial distress risk overwhelms the tax benefit.