Cost of Capital Lab
Class 2: Cost of capital
Week 2: Cost of Capital
Understanding how to calculate the appropriate discount rate for valuing projects and investments. The key insight: WACC must be project-specific, not firm-specific.
⚡ The One Idea to Internalise
WACC is project-specific. The common intuition "a project is good if it returns more than our firm's WACC" is conceptually flawed. Different projects have different risks, so you must build a WACC that matches the project's risk profile using pure-play comparables — not just plug in the firm's existing WACC.
Main Concepts
📊 WACC Formula
The weighted average cost of capital combines equity and debt costs, weighted by market values. The tax shield reduces the effective cost of debt.
📈 Cost of Equity (rE)
Three methods: CAPM (default, most common), DDM (for stable dividend firms), and ECM (for no-growth firms). CAPM is Paulina's preferred approach.
🔄 Beta & Leverage
Equity beta reflects both business risk and financial risk (leverage). To isolate business risk, unlever comparable betas to get asset beta, then relever to your target structure.
💰 Cost of Debt (rD)
Current borrowing cost = risk-free rate + default spread. Use credit ratings, synthetic ratings from comparables, or YTM on traded bonds. Always apply the tax shield.
🎯 Pure-Play Beta Workflow
The most exam-likely workflow from Week 2:
- Pick comparable ("pure play") firms in the same industry as your project
- Estimate each comp's equity beta (βE) from regression
- Unlever to asset beta: βA = βD × (D/V) + βE × (E/V)
- Average the comps' asset betas
- Relever to project's target D/E: βE = βA × (1 + D/E)
- Use relevered βE in CAPM to get rE
• Use market value weights, not book values
• Use target leverage from comps, not project's actual financing
• Match risk-free rate maturity to project life
• Use value-weighted market index (not equal-weighted)
• Apply marginal tax rate for progressive systems
• Using firm's WACC for a project with different risk
• Using project's financing mix as weights
• Making WACC investor-specific (the Elon Musk fallacy)
• Using book value instead of market value
• Forgetting to unlever/relever beta
📊 Inputs
📐 Formula Breakdown
⚠️ Key Insight
Project-Specific WACC: Don't use the firm's WACC blindly! The discount rate must match the project's risk, not the firm's overall risk. Use pure-play comparables to estimate target leverage and beta.
🔓 Unlever Beta
Remove leverage effect to find the underlying business risk (asset beta)
📊 Result
Different firms in the same industry have different equity betas due to leverage. Unlevering reveals the business risk that should be similar across the industry.
🔒 Relever Beta
Apply your project's target leverage to get project equity beta
📊 Result
📋 Full Pure-Play Beta Workflow
Enter comparable firms, unlever each, average, then relever to your target structure
| Comparable | βE | D/(D+E) % | βD | → βA |
|---|