Two Types of Capital, Two Costs

Where do the cost of equity and debt come from? The cost of debt is relatively straightforward: It's the interest rate a company must pay to borrow money, based on the current yield on any of the bonds the company has issued. Just as a person with an excellent credit rating can borrow from banks at lower rates than someone who has missed payments in the past, financially strong and stable companies can borrow at lower rates than riskier firms.

How cost of equity is figured

The cost of equity is a little more complicated and is often a topic of debate in both academia and the business world. Modern finance theory says that a given company's cost of equity is determined by measuring the risk-free rate investors can achieve (typically the yield on Treasuries) and an equity premium, with this premium determined by the company's stock volatility. The calculation under this theory is called the capital asset pricing model (CAPM), but it doesn't always work well in practice. After all, a stock's volatility (which is subject to Mr. Market's temperamental ways) really doesn't tell you much about the fundamental factors that pose a risk to future cash flows.

How we arrive at the cost of equity

When we value companies (for example, at a firm such as Morningstar), we come up with a cost of equity for each company based on a variety of risk factors: how cyclical its business is, how big it is, how much cash flow it generates, the strength of its balance sheet, and its economic moat. One might say that we use a "fundamental risk premium."

We start by assuming that the average risk-free rate over time will be 5.0%, and that the average risk premium will be 5.5%. In other words, for the perfectly average company with the perfectly average risk profile, we assume the cost of equity is 10.5% (based on the 5.0% risk-free rate plus a 5.5% equity risk premium). We then adjust the risk premium up or down to capture any other risks highlighted in the fundamental factors above.

Using this system, the costs of capital that analysts come up with generally range between 8% and 14%. Companies at the low end of this range tend to be stable, large-cap firms. On the other hand, riskier companies where future cash flows are more difficult to predict, such as many biotech firms, usually end up with higher weighted average cost of capital (WACC).

Comparing debt to equity

It's important to note that in general, debt usually costs less than equity. One reason for this is that the interest payments associated with debt are tax deductible, thus lowering the company's cost structure. As a result, a company with a large debt load will usually enjoy a lower WACC than a less leveraged firm. Of course, an increasing debt load can lead to bankruptcy risk if a company can't meet its interest and repayment obligations. When a company takes on so much debt that it becomes financially unsound, both its cost of debt and equity will rise exponentially, causing its cost of capital to rise as well.

To reiterate, a higher WACC, or discount rate, will lead to a lower estimated present value of future cash flows, and vice versa. The riskier a company is, the higher its discount rate should be, and the lower the value of its future cash flows, all else equal. Conversely, stable companies with predictable cash flows and strong competitive advantages will generally warrant a lower discount rate.