The Cost of Capital is the expected rate of return that the market requires to attract funds to a particular investment. The riskier the investment opportunity, the higher the expected cost of capital and vice versa. In business valuation analysis, the most applicable cost of capital is the Weighted Average Cost of Capital (WACC) which is the discount rate business valuators apply to convert future economic earning (cash flows) to the present value in the determination of the fair market value of a business entity. It involves the assignment of weights to equity and debt, based on the capital structure of the business entity, for the determination of the cost of all financing sources in the business enterprise's capital mix. The cost of capital includes the cost of debt, the risk-free rate which is the return on risk-free instruments such as the treasury bills, the equity risk premium (which is the required rate of return on listed equities or privately held firms) which compensates for the additional risks associated for investing in equities. The applicable cost of capital is the Weighted Average Cost of Capital (WACC) which is the discount rate which business valuators apply to convert future economic earning (cash flows) to the present value. It involves the assignment of weights to equity and debt, based on the capital structure of the business entity, for the determination of the cost of all financing sources in the business enterprise's capital mix. The WACC is computed as the cost of debt plus the cost of equity where the cost of equity is computed as follows:
Cost of Equity = Rf + bx(MRP)
Where:
Rf = Risk-Free Rate
bx = Beta
(MRP) = Market Risk Premium
bx(MRP) = Equity Risk Premium