In plain English
A company funds itself in two ways. It borrows — that is debt, and it must be paid back with interest whatever happens. Or it sells a share of itself — that is equity, and those owners get whatever is left over, which might be a lot or nothing. Debt is cheaper but unforgiving; equity is expensive but patient.
The advanced view
Debt is cheaper because its claim is senior and its interest is usually tax-deductible, but each additional krona of leverage raises the probability of financial distress and the required return on the residual claim. The weighted average of the two required returns — the WACC — is the hurdle every project must clear, and it is set by the risk of the assets, not by the mix used to buy them.
Lenders get paid first and get a fixed amount, so they take less risk and demand less return. Shareholders get paid last and get whatever remains, so they take more risk and demand more return. That single ranking explains nearly every financing decision a company makes.
'Cost of capital' sounds technical but is simply the return the people funding you expect. If lenders want 5% and shareholders want 12%, and the company is funded half and half, the blended expectation is around 8.5%. Any project earning less than that destroys value even if it makes an accounting profit — because the money could have been used for something that cleared the bar.
The blend, in plain arithmetic
Cost of capital ≈ (share of debt × cost of debt) + (share of equity × cost of equity) After tax, interest costs less: cost of debt × (1 − tax rate)
Essential vocabulary
- Interest
- What lenders are paid for the use of their money. A contractual cost.
- Dividend
- Cash paid out to shareholders from profits. Optional, not contractual.
- Cost of equity
- The return shareholders expect for taking the residual risk. Never appears on the income statement, but it is real.
- Cost of capital
- The blended return all funders expect. The minimum a project must earn.
- Default
- Failing to make a required debt payment. The reason leverage has a limit.
Common pitfalls
- ×Thinking equity is free because dividends can be skipped. Shareholders still demand a return, and they show it by selling.
- ×Loading up on debt because it looks cheap, ignoring that each extra krona raises the risk of both claims.
- ×Judging a project against the interest rate on the loan that happens to fund it rather than the blended cost of capital.
Why it works
Capital is scarce and always has an alternative use, so the return available elsewhere at the same risk is the true cost of using it here. Blending the two funders' expectations by their weights gives one hurdle rate — and comparing a project's return with that hurdle is the whole of corporate finance in miniature.
How it is used — should the project go ahead?
Step 1 of 6
- 1Funding: 40% debt at 5%, 60% equity at 12%. Tax 25%.
Deeper
Deeper: why the cost of capital is a blend, and why debt is cheaper
Debt is cheaper than equity for two reasons: lenders are paid first (less risk, so a lower required return) and interest is tax-deductible, so the government pays part of it. After-tax cost of debt = kd × (1 − t). Equity holders sit last in the queue and demand more.
That does not make more debt always better. As leverage rises, both the lenders and the shareholders demand more, because the equity's cash flows become more volatile. Modigliani–Miller with taxes says value rises with the tax shield; in practice it is offset by distress costs, so there is an interior optimum, usually expressed as a target net debt / EBITDA.
Must know cold
- ✓WACC = E/(D+E) × ke + D/(D+E) × kd × (1 − t), all at market values.
- ✓CAPM: ke = rf + β × ERP.
- ✓After-tax cost of debt = kd × (1 − t).
- ✓Levered beta rises with D/E: βL = βU × [1 + (1 − t) × D/E].
Exercises
Try each one on paper before revealing the worked solution.
Exercise 1
Equity 600 at ke 10%, debt 400 at kd 6%, tax 25%. What is WACC?
Exercise 2
The company swaps 200 of equity for 200 of debt. Why does WACC not fall by the full spread?