Cost of Equity and Cost of Debt Explained
Cost of equity comes from CAPM, cost of debt from the after-tax yield on borrowing. See both formulas, a worked example, and how they feed WACC.
Jun 2, 2026 · 8 min read
The cost of equity is the return shareholders require to hold a stock, and the cost of debt is the after-tax rate a company pays to borrow. The cost of equity is almost always estimated with the Capital Asset Pricing Model: the risk-free rate plus beta times the equity risk premium. The cost of debt starts from the yield on the company's debt, then gets multiplied by (1 minus the tax rate) because interest is tax-deductible. Both are the two inputs to WACC, the blended discount rate in a DCF. The cost of equity is higher than the cost of debt because equity holders get paid last and have no guaranteed return, so they demand more.
TL;DR
- Cost of equity via CAPM: risk-free rate plus beta times the equity risk premium, per Corporate Finance Institute.
- Cost of debt: the yield on the company's debt times (1 minus the tax rate).
- Cost of equity is always higher than cost of debt because equity is riskier and unsecured.
- Equity risk premium typically runs 4 to 6 percent; the risk-free rate uses the 10-year government bond.
- Both feed WACC, weighted by each capital source's share of total capital, per Wall Street Prep.
What are the cost of equity and cost of debt?
The cost of equity and the cost of debt are the two prices a company pays for its capital. The cost of equity is the return equity investors demand for the risk of owning the stock, since they have no contractual right to any payment and rank last in a bankruptcy. The cost of debt is the interest rate lenders charge, reduced by the tax benefit of deducting interest. According to Corporate Finance Institute, the cost of equity is "the rate of return a company pays out to equity investors," and equity financing is typically more expensive than debt. Together they form a company's overall cost of capital, blended into WACC and used as the discount rate in valuation.
How do you calculate the cost of equity?
The cost of equity is calculated with the Capital Asset Pricing Model (CAPM), which ties required return to one risk factor: how much the stock moves with the broader market. Per CFI, the formula is:
Rf is the risk-free rate, usually the yield on a 10-year government bond. Beta measures the stock's volatility relative to the market, where a beta of 1 moves with the market, below 1 is less volatile, and above 1 is more volatile. The term (Rm minus Rf) is the equity risk premium, the extra return investors expect for holding stocks over risk-free bonds, which Wall Street Prep notes typically runs 4 to 6 percent. Multiply the premium by beta, add the risk-free rate, and you have the required return on equity. Using Wall Street Prep's numbers, a 2.5 percent risk-free rate, a beta of 1.2, and a 5 percent equity risk premium give a cost of equity of 8.5 percent.
How do you calculate the cost of debt?
The cost of debt is the rate a company currently pays to borrow, adjusted for taxes. You start with the pre-tax cost: the yield to maturity on the company's outstanding bonds, or the risk-free rate plus a credit spread for the firm's rating, per Wall Street Prep. Then you multiply by (1 minus the tax rate), because interest expense is deductible and lowers the tax bill. The after-tax formula is:
Wall Street Prep's worked example: a company with a 10 percent cost of debt and a 25 percent tax rate has an after-tax cost of debt of 7.5 percent, since 10 percent times (1 minus 0.25) equals 7.5 percent. This tax shield is the reason debt is the cheaper source of capital, on top of debt already carrying less risk than equity. The pre-tax yield reflects the company's credit quality, so a riskier borrower pays a higher rate before the tax adjustment even applies.
Why is the cost of equity higher than the cost of debt?
The cost of equity is higher than the cost of debt because equity holders take more risk and rank last in the capital structure. Per CFI, the cost of equity exceeds the cost of debt because "debtholders are paid before equity investors" and receive "guaranteed payments," whereas equity investors do not. Debt payments are fixed and predictable; a company can skip a dividend without defaulting, but missing an interest payment triggers default. Debt is often secured by specific assets, while equity is a residual claim on whatever is left. Layer the tax shield on top, since interest is deductible and dividends are not, and after-tax debt becomes cheaper still. This ranking holds for almost every company and is a standard interview answer.
| Item | Cost of equity | Cost of debt |
|---|---|---|
| How it's estimated | CAPM: Rf plus beta times ERP | Yield to maturity on debt |
| Tax treatment | No tax shield (dividends not deductible) | After-tax: rate times (1 minus T) |
| Risk and ranking | Residual claim, paid last, unsecured | Senior claim, paid first, often secured |
| Required return | Higher | Lower |
| Typical inputs | Rf, beta, equity risk premium of 4 to 6 percent | YTM or risk-free rate plus credit spread |
How do the cost of equity and cost of debt feed WACC?
The cost of equity and the after-tax cost of debt feed WACC by being weighted by each source's share of total capital, then summed. Per Wall Street Prep, WACC equals the equity weight times the cost of equity plus the debt weight times the after-tax cost of debt:
E is the market value of equity, D the market value of debt, and V the total. The weights use market values, not book values, because WACC reflects the cost of raising capital today. WACC is the discount rate in a DCF, where you discount unlevered free cash flow because that cash belongs to both lenders and shareholders. For a fuller treatment of the weights, the tax shield, and how WACC behaves, see WACC explained. Because beta is observed for a leveraged company, analysts often unlever and relever it to match the target capital structure before plugging it into CAPM.
Frequently Asked Questions
What is the cost of equity in simple terms?
The cost of equity is the return shareholders require for taking on the risk of owning a company's stock. Because equity holders have no guaranteed payments and are paid last in a bankruptcy, they demand a higher return than lenders. Analysts estimate it with CAPM: the risk-free rate plus beta times the equity risk premium.
Why is the cost of debt multiplied by (1 minus the tax rate)?
Interest expense is tax-deductible, so every dollar of interest a company pays lowers its taxable income and its tax bill. Multiplying the pre-tax cost of debt by (1 minus the tax rate) captures this tax shield and gives the true after-tax cost of borrowing, which is what feeds WACC and affects the company's value.
What risk-free rate and equity risk premium should you use?
The risk-free rate is usually the yield on a 10-year government bond, since it matches the long horizon of a DCF. The equity risk premium, the extra return investors expect for holding stocks over risk-free bonds, typically runs 4 to 6 percent per Wall Street Prep. Practitioners often source the premium from historical or implied market data.
How do you find a company's cost of debt?
Take the yield to maturity on the company's outstanding bonds, which reflects what lenders charge today. If the company has no traded debt, add a credit spread for its rating to the risk-free rate, or use the rate on recent borrowings. Then multiply by (1 minus the tax rate) to get the after-tax cost.
Can the cost of equity ever be lower than the cost of debt?
In practice, almost never. Equity holders rank below lenders, have no guaranteed return, and lose the tax shield that debt enjoys, so they require more. The cost of equity falling below the pre-tax cost of debt would imply equity is less risky than debt for the same firm, which contradicts the capital structure.
How do the cost of equity and cost of debt relate to enterprise value?
Both feed WACC, and discounting unlevered free cash flow at WACC produces enterprise value, because that cash and that rate both reflect all capital providers. You then bridge to equity value by subtracting net debt, as covered in enterprise value vs equity value.
Sources
- Corporate Finance Institute, "Cost of Equity: Formula, Guide, How to Calculate": https://corporatefinanceinstitute.com/resources/valuation/cost-of-equity-guide/ (checked June 2026)
- Wall Street Prep, "WACC Guide: Formula and Calculation Example": https://www.wallstreetprep.com/knowledge/wacc/ (checked June 2026)
- Corporate Finance Institute, "WACC Formula, Definition and Uses": https://corporatefinanceinstitute.com/resources/valuation/what-is-wacc-formula/ (checked June 2026)