Between 2015 and 2021 a well-rated European corporate could issue five-year bonds with a coupon below 1%. Some issued at negative yields. Boards approved projects on the basis that money was effectively free, and judging by the coupon payments it was.

This temporary depression in rates gave a false illusion of the cost of capital. The equity behind those bonds still expected 8% or more, and the tax shield (one of the biggest advantages of debt funding) on a 0.5% coupon is worth almost nothing. The companies that confused a cheap coupon with cheap capital spent 2023 explaining why the return on their 2019 acquisitions was below the cost of refinancing them.

This article sets out what capital actually costs and how it is calculated.

Cost of debt

The cost of debt is built from the bottom up.

  • The base is a Risk-free rate: what a government of unquestioned credit pays to borrow for the same term. In practice the Bund for euro, the gilt for sterling, the Treasury for dollars. Nobody lends to a company at that rate.
  • The Risk-free rate itself is largely determined by Central Bank interest rate policy. A 50bps cut from the ECB will have an impact on all euro financing, risky or otherwise. Most of the price in the short end of the curve is driven by expectations of central bank actions from meeting to meeting. They don't like to shock markets, so tend to signal rate changes in advance, although new Fed governor Kevin Warsh has indicated that the Fed may be less committed to this approach under his watch.
  • On top sits the Credit spread: the extra yield that compensates the lender for the chance you don't repay. It moves with your own credit quality and with the market's general appetite for risk. A BBB issuer might pay 100-150 basis points over risk-free in a calm market or twice that when uncertainty rises.

Two further layers depend on who and where you are.

  • A liquidity premium compensates investors for paper that is hard to sell: a €50m private placement pays more than a €500m benchmark bond from the same issuer because there is no ready market to exit through.
  • Country risk is the premium attached to the jurisdiction rather than the company. An Irish or Dutch issuer inherits a low sovereign spread; a strong issuer in a higher risk jurisdiction may have their credit rating capped at that of the sovereign.
  • Then the tax shield. Interest is usually paid before taxable profit is calculated. The after-tax cost of debt is the pre-tax cost times one minus the tax rate.
How the cost of debt is built from the bottom up: a risk-free rate set largely by central bank policy, plus a credit spread of 100 to 150 basis points for a BBB issuer in a calm market, plus a liquidity premium for paper that is hard to sell, plus country risk attached to the jurisdiction rather than the company, giving the pre-tax cost of debt. How the cost of debt is built from the bottom up: a risk-free rate set largely by central bank policy, plus a credit spread of 100 to 150 basis points for a BBB issuer in a calm market, plus a liquidity premium for paper that is hard to sell, plus country risk attached to the jurisdiction rather than the company, giving the pre-tax cost of debt.

The four layers over a government's borrowing rate.

After Tax Cost of Debt = Interest Rate x (1 - Tax Rate)

At 25%, a 5% coupon costs 3.75%. At Ireland's 12.5% trading rate the shield is worth half as much. Interest deductibility caps under the EU anti-tax-avoidance rules and the UK corporate interest restriction can remove it for highly leveraged groups, and it is only worth anything if there are taxable profits to shelter.

The tax shield: the after-tax cost of debt equals the interest rate times one minus the tax rate. At a 25% tax rate a 5% coupon costs 3.75%; at Ireland's 12.5% trading rate the same coupon costs 4.38%, so the shield is worth half as much. Deductibility caps can remove it, and it is only worth anything if there are taxable profits to shelter. The tax shield: the after-tax cost of debt equals the interest rate times one minus the tax rate. At a 25% tax rate a 5% coupon costs 3.75%; at Ireland's 12.5% trading rate the same coupon costs 4.38%, so the shield is worth half as much. Deductibility caps can remove it, and it is only worth anything if there are taxable profits to shelter.

The one layer that takes the cost back down.

Cost of equity

Equity has no coupon, it is an easy mistake to treat it as free. It is the most expensive money a company can access. Shareholders take the first loss and the last payment, and price accordingly. The standard estimate is the Capital Asset Pricing Model:

Return on Equity = Risk-free rate + (Equity Risk Premium x beta)

  • Equity Risk Premium what equities are expected to return over the risk free rate.
  • Beta a measure of how much more volatile your shares are than the market.

A beta of 1.2, a risk-free rate of 3% and a 5% premium give a cost of equity of 9% (3% + 1.2 x 5%).

For a private company the beta is borrowed from listed peers.

The Capital Asset Pricing Model: return on equity equals the risk-free rate plus the equity risk premium times beta. The risk-free rate is what a government of unquestioned credit pays for the same term; the equity risk premium is what equities are expected to return over the risk-free rate; beta measures how much more volatile your shares are than the market, and is borrowed from listed peers for a private company. Worked through: 3% plus 1.2 times 5% gives a 9% cost of equity. The Capital Asset Pricing Model: return on equity equals the risk-free rate plus the equity risk premium times beta. The risk-free rate is what a government of unquestioned credit pays for the same term; the equity risk premium is what equities are expected to return over the risk-free rate; beta measures how much more volatile your shares are than the market, and is borrowed from listed peers for a private company. Worked through: 3% plus 1.2 times 5% gives a 9% cost of equity.

Equity never sends an invoice, which is why it is the cost most often left out.

Weighted Average Cost of Capital (WACC): putting it all together

The weighted average cost of capital is the combined cost of the Debt and Equity in a company, weighted by volume issued.

WACC = (E / V x Cost of Equity) + (D / V x Cost of Debt x (1 - Tax Rate))

E is the equity, D is the debt, and V is the two added together.

The weighted average cost of capital: WACC equals the equity share of the capital times the cost of equity, plus the debt share times the cost of debt times one minus the tax rate. Worked on a company funded 60% by equity at a 9% cost of equity and 40% by debt at a 5% coupon with a 25% tax rate: 0.6 times 9% gives 5.4%, 0.4 times 3.75% gives 1.5%, for a WACC of 6.9%. The weighted average cost of capital: WACC equals the equity share of the capital times the cost of equity, plus the debt share times the cost of debt times one minus the tax rate. Worked on a company funded 60% by equity at a 9% cost of equity and 40% by debt at a 5% coupon with a 25% tax rate: 0.6 times 9% gives 5.4%, 0.4 times 3.75% gives 1.5%, for a WACC of 6.9%.

Both demand higher returns as the risk profile of the company rises.

Debt is cheaper, and has the advantage of reducing tax burden. As you add debt initially, the cost of capital reduces, but only up to a point.

Beyond that point, the added risk of higher leverage, and a lower equity cushion makes the debt more expensive and the combined cost of debt and equity rises.

Optimal debt/equity structure. Three lines plotted against cost of capital, running from more equity on the left to more debt on the right. The cost of equity rises steadily across the range and then steeply at the right-hand end. The cost of debt is far lower on the left and climbs faster and faster as debt is added. The weighted average cost of capital falls as the first debt is added, reaches a minimum a little left of centre at the optimal debt/equity ratio, and then rises as the added risk of higher leverage makes both debt and equity more expensive. Optimal debt/equity structure. Three lines plotted against cost of capital, running from more equity on the left to more debt on the right. The cost of equity rises steadily across the range and then steeply at the right-hand end. The cost of debt is far lower on the left and climbs faster and faster as debt is added. The weighted average cost of capital falls as the first debt is added, reaches a minimum a little left of centre at the optimal debt/equity ratio, and then rises as the added risk of higher leverage makes both debt and equity more expensive.

The lowest point on this curve is the optimal weighted average cost of capital. This is the cheapest funding mix for the business.

It is an important number, not only for determining the cost of funding something, but also determining whether a project should be funded or not. If a project doesn't pass the WACC hurdle, it may generate cash, but it won't create value for the business.

Marginal versus average

The average cost of existing funding is a historical fact, and the number the board is used to hearing. The marginal cost is what the next euro costs, and it is the only number relevant to a new decision. A company sitting on 2021 bonds at 1.5% does not have a 1.5% cost of debt for the acquisition it wants to fund in 2026; it has whatever the market charges today.

The treasurer's job is to look at the marginal cost, even when the average is the more comfortable number.

Other costs

Servicing costs and expected return are the main costs of raising debt or issuing equity, but there can be many other costs that sit outside of the WACC calculation that a treasurer needs to take into account when assessing the cost of debt.

  • Issuance and listing fees
  • Rating agency fees
  • Structuring costs
  • Legal fees
  • Advisory fees
  • Hedging costs
  • Monitoring costs
  • Additional staff costs (e.g. Investor Relations)

And many others. Some apply equally to both debt and equity, some more one than the other, and some are exclusive to Debt or Equity. All should be considered and understood when assessing the cost of a capital raise.

Other considerations

As we cover in the article on Designing the Optimal Capital Structure, cost is only one consideration when determining optimal capital structure. There are many others, and they often outweigh the simple consideration of cost. Don't ignore them.

The same job at three sizes

Start-up. The cost of equity is the only cost that matters and it is brutal at the start. … read more show less

Each round prices the company, and the investor's return expectation is the true cost of capital. A convertible or SAFE defers the calculation rather than avoiding it. Debt, where it exists, is priced like equity.

Established mid-market. WACC becomes a practical tool for capital allocation. … read more show less

The temptation is to run projects against the cost of debt because that is the number with an invoice attached. Resist it. The other trap is treating the bank margin as the cost of debt and forgetting the fees, hedging and covenant constraints stacked on top.

Large corporate. A formal WACC, refreshed regularly, published as the hurdle rate. … read more show less

It is discussed at length with rating agencies and equity analysts who each have their own version. The treasurer manages the marginal cost across markets: where a bond beats a loan, where a private placement's liquidity premium is worth paying for tenor, and where the tax shield benefits most.