COST OF CAPITAL AND THE DISCOUNT RATE

One guide to selecting the proper discount rate is to consider the cost of
capital. This measure is useful in capital budgeting because only one firm is
involved. The cost of capital for a given company can be generally derived
through:

(15.7)
Let us consider a simple example of a firm whose capital structure is
composed of 50% debt and 50% equity. The weights for each source are
0.50. If the debt rate is 9% and the rate of return on equity is 15%, the cost
of capital can be computed as follows:
(15.8)

COST OF DEBT
The after-tax debt rate reflects the true cost of debt, given the fact that debt
is a tax-deductible expense. The after-tax rate of debt can be determined as
follows:

(15.9)
where:

kt = the after-tax cost of debt

kd = the pretax cost of debt

t = the actual corporate tax rate for the firm

Cost of Equity

A simple guideline in deriving the cost of equity is to consider that the rate
of equity is generally 4% to 6% higher than the rate of debt. The rate of debt
may be clear if the firm does not have many different types of debt. In this
case, the debt rate is given, and 4% to 6% can simply be added to derive the
rate for equity.
Another way to look at the appropriate rate on equity is to consider the
long-term risk premium. This is the difference between the long-term
average rate on risk-free T-bills and the rate on equities. Historically, this
has been between 6% and 7%. However, there has been much debate
regarding whether the appropriate risk premium should be lower, given
what some see as one-time factors and institutional changes that would
make the difference in return on these securities less in the future than it
has been in the past.8

Cost of capital for a private company should be higher…illiquidity premium. For a larger enterprise
premium not as high as there will be a more robust market for the equity