Concise interview answer to what the difference of cost of capital vs WACC?
What is the Cost of Capital vs. the WACC?
When talking about discount rates, the term "cost of capital" and "WACC" are sometimes used interchangeably - but it is important to draw a distinction between the two. Put simply, the cost of capital is a generic term for the cost of obtaining capital to run a business.
What is Weighted Average Cost of Capital (WACC)?
WACC represents the cost that a company incurs to obtain capital that can be used to fund operations, investments, etc. The Weighted Average Cost of Capital includes the cost of equity financing (issuing shares to investors), debt financing (issuing debt to debt investors).
Now we bring them all together to find WACC.
WACC = cost of debt + cost of equity + cost of preferred stock
What is the Debt Cost of Capital?
The cost of debt looks at the amount of debt in the capital structure and then multiplies that by the weighted average interest rate. This is done to reflect the interest rates of the company's debt - which is the cost of having debt investors. Then you multiply by (1 - tax rate) since interest payments are tax deductible.
Since interest payments are paid before paying taxes - by increasing the amount of interest payments you end up paying less taxes then you previously did.
Cost of Debt = weighted average interest rate * (% of debt in the capital structure) * (1 - tax rate)
What is the Equity Cost of Capital?
This is the cost associate with selling part of a company to investors. The equation can be seen below.
Cost of Equity = Capital Asset Pricing Model * (% of equity in the capital structure)
Put in simple terms, CAPM is the equity equivalent of the weighted average interest rate for debt.
Capital Asset Pricing Model = risk free rate + Beta * market risk premium
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