Meaning and transaction use
Damodaran defines cost of capital as the weighted average of the cost of equity and after-tax cost of debt, using market-value weights. [S1]
Damodaran's WACC framework includes equity, debt and preferred stock as separate financing components and describes their market-value proportions in the funding mix. [S2]
The discount-rate and cash-flow definitions should match by claim holder, currency, tax basis, inflation basis and risk; the resulting rate is an analytical input, not an observed transaction price.
Worked example
Illustrative calculation only. Assume market-value equity of 70.0 million, debt of 30.0 million, no preferred capital, a 14.0% cost of equity, an 8.0% pre-tax cost of debt and a 25.0% tax rate.
Scroll the table horizontally to view all columns.
| Measure | Calculation | Result |
|---|---|---|
| Equity weight | 70.0 / (70.0 + 30.0) | 70.0% |
| Debt weight | 30.0 / (70.0 + 30.0) | 30.0% |
| After-tax cost of debt | 8.0% x (1 - 25.0%) | 6.0% |
| Equity contribution | 14.0% x 70.0% | 9.8% |
| Debt contribution | 6.0% x 30.0% | 1.8% |
| Illustrative WACC | 9.8% + 1.8% | 11.6% |
The illustrative WACC is 11.6%. It applies only to cash flows that match the assumed risk, currency, inflation, tax and financing basis. A different capital structure or component cost produces a different result.
Proposed transaction review process
Define the cash flows
Identify the valuation perimeter, claim holders, currency, inflation basis, tax basis and risk profile.
Estimate component costs
Support the cost of equity, borrowing cost, tax treatment and any preferred or hybrid cost with dated evidence.
Set market-value weights
Estimate the relevant market values of equity, debt and other financing components on a consistent date.
Calculate and test
Compute WACC, test material inputs and reconcile the rate to the DCF, market evidence and project-specific risks.
Evidence checklist
Cost of equity
Risk-free rate, equity risk premium, beta or asset-risk approach, country and size adjustments, with rationale.
Cost of debt
Current borrowing terms, credit spread, maturity, currency, security and refinancing evidence.
Tax and capital structure
Marginal tax analysis, interest deductibility, market values and target financing assumptions.
Consistency controls
Cash-flow definition, valuation date, forecast currency, nominal or real basis and project-risk assessment.
Decision framework
| Situation | Proposed action |
|---|---|
| Market debt value is unavailable | Estimate it using supportable terms and disclose the method and sensitivity. |
| Leverage is expected to change materially | Use a valuation method or period-specific rates that reflect the financing path. |
| The project risk differs from the company | Develop a project-specific rate or explicit risk adjustment with documented support. |
| The tax shield is uncertain | Model the supportable tax benefit and sensitise the result rather than assuming full deductibility. |
Common errors to check
- Using book-value weights without analysing current market values.
- Applying a historical coupon as the current cost of debt without testing refinancing risk.
- Adding risk premiums that are already reflected in the forecast or another rate input.
- Using WACC to discount equity cash flows or cash flows with a different currency or inflation basis.
Test the cost-of-capital assumptions
Bring the cash-flow definition, capital structure, borrowing evidence, equity-risk inputs and tax analysis to a WACC review. Reconcile each assumption to the valuation date and test the result across supportable scenarios.
Discuss the transactionPrimary references and editorial scope
- Aswath Damodaran, Variables Used in Data Set
Cost-of-capital definition, after-tax debt cost and market-value weighting. Reference checked 17 September 2026. - Aswath Damodaran, Definition of the Weighted Average Cost of Capital
WACC formula, financing components and market-value weights. Reference checked 17 September 2026.
General valuation education. Figures are hypothetical. The appropriate discount rate depends on the entity, project, valuation purpose, date, currency, tax position, capital structure and applicable accounting, tax, legal and regulatory requirements.
General business information. Obtain advice appropriate to the legal, tax, accounting and financing facts. No offer, lender commitment or transaction outcome is represented. All worked examples use expressly assumed figures. Editorial draft date: 17 September 2026.
