Damodaran on Valuation

2.3. FROM COST OF EQUITY TO COST OF CAPITAL

While equity is undoubtedly an important and indispensable ingredient of the financing mix for every business, it is but one ingredient. Most businesses finance some or much of their operations using debt or some hybrid of equity and debt. The costs of these sources of financing are generally very different from the cost of equity, and the cost of capital for a firm will reflect their costs as well, in proportion to their use in the financing mix. Intuitively, the cost of capital is the weighted average of the costs of the different components of financing—including debt, equity, and hybrid securities—used by a firm to fund its financial requirements.

2.3.1. Estimation Approaches

As with cost of equity, there are a number of different ways in which we can estimate the costs of capital. In this subsection, we consider three: the unlevered cost of equity approach, the implied rate of return approach, and the weighted average cost approach.

2.3.1.1. Unlevered Cost of Equity

Earlier in this chapter, we considered the relationship between equity betas and leverage and introduced the notion of an unlevered beta (i.e., the beta that a company would have it if it were all equity financed). The cost of equity that would result from using an unlevered beta is called the unlevered cost of equity:

Unlevered cost of equity = Risk-free rate + Unlevered beta × Risk premium

There are some analysts who use the unlevered cost of equity as the cost of ...