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Cost of Capital

What a company's cost of capital represents, how the cost of equity is estimated with the capital asset pricing model, how debt and equity combine into WACC, and which rate goes with which cash flows.

Lesson 2 of 7 · 5 min read · Intermediate · Members · Last reviewed October 2026

The short version

A company's cost of capital is the return its investors require for funding it, and it's the discount rate for valuing its cash flows. The cost of equity is often estimated with the capital asset pricing model: a safe interest rate plus beta times the equity risk premium. The cost of debt is the company's borrowing rate, reduced by the tax deduction for interest. Weighting the two by their share of the company's funding gives the weighted average cost of capital, or WACC. Every input is an estimate, so it's best treated as a range.

By the end of this lesson, you'll be able to

  • Estimate a cost of equity with the capital asset pricing model
  • Calculate a weighted average cost of capital
  • Match the right discount rate to the right kind of cash flow

Why this matters

The last lesson showed that a valuation depends heavily on the discount rate. For a company, that rate is its cost of capital: the return investors require in exchange for funding it. It's also the hurdle every new project should clear. As Management and Capital Allocation showed, investing at returns below the cost of capital destroys value, even when it makes the company bigger.

The cost of equity

Shareholders take more risk than lenders, so they require a higher return. The most widely taught way to estimate it is the capital asset pricing model, or CAPM, part of the work for which William Sharpe shared the 1990 Nobel Memorial Prize in Economic Sciences.1

Cost of equity = Risk-free rate + Beta × Equity risk premium

  • The risk-free rate is a safe return, usually a Treasury yield. The 10-year Treasury yielded 5.29% on September 30, 2026.2
  • The is the extra return investors expect from stocks as a whole over safe bonds. Estimates vary. NYU Stern professor Aswath Damodaran estimated it at about 4.5% for the US at the start of 2026.3
  • measures how much a stock adds to the risk of the overall market. A beta above 1 means more than average, below 1 less than average. In the CAPM, a stock's expected risk premium rises in proportion to its beta.1

The cost of debt

Lenders require the interest rate on the company's debt. Because companies can generally deduct the interest they pay from their taxable income, the real cost is lower than the rate itself.4

After-tax cost of debt = Interest rate × (1 − Tax rate)

The rest of this lesson is for members

Still to come in this lesson: Putting them together: WACC, Which rate goes with which cash flow, the key takeaways, and 2 quiz questions with explanations.

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Notes and sources

  1. Nobel Prize Outreach. The Prize in Economic Sciences 1990: Press release. Checked 2026-10-11. Back to text
  2. U.S. Department of the Treasury. Daily Treasury Par Yield Curve Rates. Checked 2026-10-01. Back to text
  3. 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
  4. Legal Information Institute, Cornell Law School. 26 U.S.C. 163: Interest (deduction, and the business interest limit in subsection (j)). Checked 2026-10-01. Back to text