Cost of Capital: the Full Build

Learning objectives

By the end you can:

1. Set a currency-matched risk-free rate for any valuation: state the two conditions that make a rate risk-free, explain why the Indian G-sec yield fails one of them, execute Damodaran's clean-INR fix (G-sec yield minus the sovereign default spread), and apply the rule that the currency of the cash flows dictates the currency of every rate in the stack.
2. Build a bottom-up beta from scratch: unlever a set of peer regression betas with βU = βL / [1 + (1−t)·D/E], average away their noise, and relever to the target's market-value capital structure with βL = βU × [1 + (1−t)·D/E]. Explain, with the standard-error arithmetic, why this beats any single regression beta.
3. Compute and correctly deploy total beta (market beta ÷ correlation with the market) for undiversified owners, and state precisely when it applies and when it must not be used.
4. Assemble a cost of equity from clean Rf + β × (mature ERP + λ·CRP), for domestic firms and exporters, in INR or USD, without double-counting country risk.
5. Estimate a cost of debt three ways (traded-bond YTM, actual rating → spread, and a synthetic rating read off the interest-coverage ratio using Damodaran's lookup table), convert it to after-tax at the marginal rate, and add the country default spread for emerging-market borrowers.
6. Compute market-value weights: convert book debt to market value with the one-bond approximation, include lease liabilities under ASC 842 / IFRS 16 / Ind AS 116, and defend the choice of market over book values.
7. Assemble the full WACC and sanity-check it against market-level ranges, then run the complete blank-sheet build on one Indian and one US company, citing a live source for every input.
8. Spot and fix the ten classic WACC errors in someone else's (or your own) computation.

Prerequisites & connections

Builds on. M3.02 directly: the mature-market implied ERP, the country risk premium (default spread × relative equity volatility), λ exposure-weighting, CAPM, and beta as co-movement. All of them arrive here as finished inputs, and M3.02's illustrative mid-2026 values carry over (US Rf 4.2%, mature ERP 4.3%, India default spread 2.0%, CRP 2.8%, India ERP 7.1%, clean INR Rf 4.5%, every one to be re-pulled live before real use). M3.01 (Fisher real↔nominal logic; PV of an annuity, used to mark debt to market). M2.02–M2.03 (coverage ratios, leverage ratios, the operating/financing separation; the synthetic rating is Phase 2's interest-coverage ratio given a price tag). M1.08 (leases as debt across the three standards; effective-interest debt mechanics).

Feeds forward. M3.04–M3.05: FCFF will be discounted at this WACC, FCFE at this cost of equity, and the never-mix rule gets teeth there. M3.06: multiples are compressed DCFs; the r inside P/B ≈ (ROE−g)/(r−g) is the Re built here. M3.07: economic profit = (ROIC − WACC) × invested capital; you are building the hurdle in that spread. M3.08–M3.09: the model stack hard-codes nothing, so your WACC sheet will cite the sources gathered here. M3.10: banks and other financials get an equity-only treatment (WACC is meaningless when debt is raw material, not financing; previewed here, delivered there).

The one-sentence version of this module. A company's cost of capital is not its preference and not its history: it is the return its investors could earn elsewhere at the same risk, in the same currency, today, and your job is to reconstruct that opportunity cost from live market evidence, piece by auditable piece.

4.1 What WACC actually is (and is not)

Start with the right side of a balance sheet, at market values. Somebody financed everything the company operates. Some lent to it, some own it. Each group parted with money it could have deployed elsewhere, and each therefore has a required return: the lenders' alternative is other bonds of the same risk; the shareholders' alternative is other equities of the same risk. The company's cost of capital is simply the value-weighted average of those two opportunity costs:

``` WACC = (E/V) × Re + (D/V) × Rd × (1 − t)

E = market value of equity D = market value of debt V = E + D Re = cost of equity Rd = pre-tax cost of debt t = marginal tax rate ```