Cost of Capital in Depth
Where the inputs to a discount rate come from, how uncertain each one is, how borrowing changes the cost of equity, and how to use a cost of capital without pretending it's precise.
The short version
The cost of capital is the return investors require, and every part of the usual calculation is an estimate. The safe rate depends on which bond you pick, the equity risk premium can't be observed, and beta changes with the period and the index used to measure it. Reasonable choices move the cost of equity by three percentage points and the value of a company by more than half. Borrowing doesn't lower the overall cost by much, because debt makes the remaining equity riskier and more expensive. The practical answer is to use a range, apply the same approach to every company you compare, and never adjust the discount rate to reach the value you were hoping for.
By the end of this lesson, you'll be able to
- Identify the sources of uncertainty in each input to the cost of equity
- Recalculate beta and the cost of equity for a different level of debt
- Explain why the weighted average cost of capital changes little across moderate levels of borrowing
Why this matters
Cost of Capital calculated a 9.8% cost of equity for STU Corp and used it to value the company. That one number moves the answer more than almost any other input. This lesson opens it up. The aim isn't a better number. It's an honest sense of how wide the range is, so the discount rate stops looking like a fact.
The three inputs
Cost of equity = Risk-free rate + Beta × Equity risk premium
The risk-free rate
This is the return on an investment with no risk of default, in practice a US Treasury yield. The choices are which maturity and which day. The earlier lesson used the 10-year Treasury, which yielded 5.29% on September 30, 2026.1 A long bond is the usual choice, because a company's cash flows stretch far into the future. Yields move every day, so a valuation done a year apart starts from a different base even if nothing about the company has changed.
The equity risk premium
The is the extra return investors require for holding shares instead of safe bonds. Nobody can observe it. There are two ways to estimate it.
- From history: the average amount by which shares have beaten bonds. The answer depends heavily on the years chosen and on how the average is calculated.
- From today's prices: the premium implied by the current level of the market and expected cash flows, in the spirit of Reverse DCF. Aswath Damodaran's estimate of this kind was about 4.5% for the US at the start of 2026.2
Estimates between 4% and 6% are all defensible, and the premium isn't fixed. It changes with how much risk investors are willing to bear.
Beta
Beta. A measure of how much a stock adds to the risk of the overall market. Above 1 means more than average; below 1 means less. More on this term measures how much a share's returns have moved with the market's. In the capital asset pricing model, a share's expected risk premium rises in proportion to its beta.3 It's estimated by comparing a share's past returns with an index, and the result depends on choices nobody can settle: two years of data or five, weekly returns or monthly, which index.
For a single company the estimate is noisy, and it describes the past. A company that has changed its business or its borrowing has a history that no longer fits. Two practical fixes are to use the average beta of similar companies, which is steadier than any one of them, and to adjust for borrowing, which the next section covers.
How much the inputs matter
| Beta | Equity risk premium | Cost of equity | Value per share |
|---|---|---|---|
| 0.8 | 4.0% | 8.5% | $55.59 |
| 1.0 | 4.5% | 9.8% | $44.69 |
| 1.2 | 5.5% | 11.9% | $33.82 |
None of these inputs is unreasonable. Together they move the cost of equity from 8.5% to 11.9% and the value of a share from under $34 to over $55, with the same forecast of cash flows in every row. STU Corp's shares trade at $50. Whether they look cheap or expensive depends on which row you believe.
The rest of this lesson is for members
Still to come in this lesson: Borrowing and the cost of equity, Other adjustments, Using it sensibly, the key takeaways, and 2 quiz questions with explanations.
Membership opens every lesson in the curriculum, the capstone projects, the interactive tools, and the members-only channels in the Hyperion Entities Discord. The first lesson of every module stays free.
Go deeper
- Debt, Covenants, and Credit RatingsCorporate Finance (depth track)
- Cost of CapitalPart 4: Research and Valuation
- Capital StructureCorporate Finance (depth track)
- Valuation Under UncertaintyValuation and Modeling (depth track)
Notes and sources
- U.S. Department of the Treasury. Daily Treasury Par Yield Curve Rates. Checked 2026-10-01. Back to text
- Aswath Damodaran, NYU Stern School of Business. Country Default Spreads and Risk Premiums (last updated January 5, 2026). Checked 2026-10-01. Back to text
- Nobel Prize Outreach. The Prize in Economic Sciences 1990: Press release. Checked 2026-10-11. Back to text