Cost of Debt is the future interest rate application to the company, net of taxes. It is calculated using Yield to Maturity less taxes, where the bonds are listed. It can also be calculated by taking the risk free rate and adding the credit default spread applicable to the credit rating of the company. Do not use Interest(1-t)/Debt. This only gives you past costs and not future costs
Cost of Equity is calculated using Capital Asset Pricing Model. DO NOT use Dividend Growth or Earnings Yield – CoE will become zero for a company that does not pay dividends and negative for a loss making company – meaningless numbers. DO NOT use IRR – IRR is the expected return (i.e. the rate of return from the project). It is not the required return. The confusion arises because people confuse “expected return” to mean the return expected by shareholders. The return shareholders “want to have” is CoE. The return they would have by investing in this project is IRR
Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return)
In this equation, the risk-free rate is the rate of return paid on risk-free investments such as 10 year Treasury Bond. Refer the question on Risk free Rate to know more. Beta is a measure of company specific undiversifiable risk. A Beta of 1.5 means that a 1% change in the index will lead to 1.5% change in this security. Refer beta explanation for more details – also refer unlevered and levered betas The higher the volatility, the higher the beta and relative risk compared to the general market.
The market rate of return is future expected return from the index of the countries in which the company operates. It does not contain company or industry level risks.
