This lesson introduces the cost of capital as a cornerstone of financial management and valuation. It covers the components of the cost of capital, the Weighted Average Cost of Capital (WACC) calculation, and the Capital Asset Pricing Model (CAPM) for estimating the cost of equity, as covered in the ETH Zurich Introduction to Finance course .

• Definition and Importance: The cost of capital is the minimum rate of return a firm must earn on its investments to maintain its market value and attract funds. It is the weighted average cost of the various sources of finance used by the firm. The cost of capital is critical for:

  • Capital Budgeting: Evaluating investment projects using discounted cash flow techniques.

  • Designing Optimal Capital Structure: Determining the right mix of debt and equity.

  • Financial Performance Appraisal: Assessing whether the firm is creating value for shareholders.

• The CAPM Framework: The Capital Asset Pricing Model describes the relationship between systematic risk and expected return for assets, particularly stocks. The course at ETH Zurich covers Introduction to Risk and Return, Portfolio Theory, and the Capital Asset Pricing Model . The formula is:

  • E(Ri) = Rf + βi × (E(Rm) – Rf)

  • Rf = Risk-free rate

  • βi = Beta, a measure of systematic risk

  • E(Rm) – Rf = Market risk premium

• The WACC Formula: The standard WACC formula is:

  • WACC = Kd(1 – t) × D/(D+E) + Ke × E/(D+E)

  • Kd = Cost of debt

  • t = Corporate tax rate

  • D/(D+E) = Weight of debt in the capital structure

  • Ke = Cost of equity

  • E/(D+E) = Weight of equity in the capital structure

• Country Risk in Cost of Capital: When valuing international companies, country risk—political and economic stability—must be incorporated into financial models, applying adjusted discount rates to compensate for the higher level of uncertainty . The International Chart provides references to standards for international business appraisals .