Almost all companies finance their operations with a mix of debt and equity capital. The costs associated with investment capital are reflected in its weighted average cost of capital. The most commonly accepted method for calculating a company's cost of equity is the capital asset pricing model. Once a company estimates its cost of equity, it can determine the weighted average of the cost of equity and the after-tax cost of debt. A company's cost of debt is based on its borrowing costs and is calculated using a simple weighted average based on the carrying value of its outstanding debt.
The costs associated with both debt and equity capital are based on opportunity cost and can be calculated based on their expected returns. The cost of equity is the return required to entice a hypothetical investor to invest in the common stock of a particular company. The cost of debt is the weighted average expected return required by the company's lenders -- its creditors -- which is the simple average of the stated interest rates of the company's debt instruments.
Capital Asset Pricing Model
The cost of equity is a more difficult calculation than the cost of debt. Think of the process as starting with a generic common stock investment based on historical average stock market returns. Historical returns are a proxy for expected returns, because the past is generally a good indicator of the future. This can be confusing, however. Is the cost of equity based on expected returns or the risk associated with the investment? The answer is both. Beginning with a "generic" stock market investment, adjust this figure upward or downward to account for risks associated with the subject company. These include growth, financial performance, liquidity and competitive risks. For a privately held company, the cost of equity will generally range between 15 percent and 25 percent.