cost-of-capital-estimator

What this skill does

# Cost of Capital Estimator

## Table of Contents
- [Example](#example)
- [Workflow](#workflow)
- [Common Patterns](#common-patterns)
- [Guardrails](#guardrails)
- [Quick Reference](#quick-reference)

## Example

**Company**: Ambev (Brazilian beverage company)
- Incorporated in Brazil; revenue split: Brazil 60%, Latin America 30%, US 10%
- Industry: Beverages (alcoholic and non-alcoholic)
- Current D/E ratio: 25% (market values); marginal tax rate: 34%

**Step 1 -- Riskfree rate (BRL analysis)**

US 10-year Treasury yield: 4.0%. Brazil government bond: 11.0%. Brazil sovereign default spread (Baa2 rating): 2.5%.

Option A -- Subtract default spread: 11.0% - 2.5% = 8.5% (riskfree rate in BRL, captures inflation differential).

Option B -- Build from US rate + inflation differential: (1.04) x (1.06)/(1.02) - 1 = 8.1% (using expected inflation: Brazil 6%, US 2%).

Use 8.5% for this analysis (Option A, simpler and directly observable).

**Step 2 -- Equity risk premium buildup**

Mature market ERP (implied, S&P 500): 5.0%.

Country risk premiums (CRP):
- Brazil: Default spread 2.5% x (equity vol / bond vol) = 2.5% x 1.5 = 3.75%
- Other LatAm (average): 3.0%
- US: 0%

Operation-weighted CRP = 0.60 x 3.75% + 0.30 x 3.0% + 0.10 x 0% = 3.15%.

Total ERP = 5.0% + 3.15% = 8.15%.

**Step 3 -- Bottom-up beta**

Comparable beverage firms (global, n=20): Median unlevered beta = 0.80.

Relever at Ambev's capital structure:
Levered Beta = 0.80 x (1 + (1 - 0.34) x 0.25) = 0.80 x 1.165 = 0.93.

**Step 4 -- Cost of equity**

Cost of Equity = 8.5% + 0.93 x 8.15% = 8.5% + 7.58% = **16.08%**.

**Step 5 -- Cost of debt (synthetic rating)**

EBIT: R$20B, Interest expense: R$2.5B. Interest coverage = 8.0x.

Lookup: Coverage of 8.0x maps to A rating for large firms, default spread = 1.00%.

Pre-tax cost of debt = 8.5% + 1.00% = 9.50%.

After-tax cost of debt = 9.50% x (1 - 0.34) = 6.27%.

**Step 6 -- WACC**

Capital structure weights (market values): E/(D+E) = 80%, D/(D+E) = 20%.

WACC = 16.08% x 0.80 + 6.27% x 0.20 = 12.86% + 1.25% = **14.12%**.

**Interpretation**: This is a BRL-denominated WACC. Use it to discount BRL-denominated cash flows. For USD-denominated analysis, rebuild using USD riskfree rate and adjust the ERP accordingly.

## Workflow

Copy this checklist and track your progress:

```
Cost of Capital Estimation Progress:
- [ ] Step 1: Determine riskfree rate for analysis currency
- [ ] Step 2: Estimate equity risk premium (mature market + country risk)
- [ ] Step 3: Estimate beta (regression or bottom-up)
- [ ] Step 4: Compute cost of equity
- [ ] Step 5: Compute cost of debt via synthetic rating
- [ ] Step 6: Compute WACC and validate
```

**Step 1: Determine riskfree rate for analysis currency**

The riskfree rate anchors the entire computation. It should be denominated in the same currency as projected cash flows.

- For USD or EUR analysis: use the 10-year government bond yield for the US or Germany.
- For emerging market currencies: subtract the sovereign default spread from the local government bond yield, or use the US rate adjusted by the inflation differential.

See [resources/methodology.md](resources/methodology.md#riskfree-rate-derivation) for the inflation-differential approach and when each method is appropriate.

**Step 2: Estimate equity risk premium (mature market + country risk)**

Build the ERP in two layers:

1. Start with the implied ERP for a mature market (S&P 500). This is the baseline premium investors demand above the riskfree rate for holding equities.
2. Add the country risk premium (CRP) appropriate for where the company operates. Weight the CRP by revenue geography, not by country of incorporation.

See [resources/methodology.md](resources/methodology.md#four-step-erp-procedure) for the four-step ERP estimation and [resources/methodology.md](resources/methodology.md#country-risk-premium-approaches) for the three approaches to corporate country risk exposure.

**Step 3: Estimate beta (regression or bottom-up)**

Bottom-up beta is preferred over regression beta because it uses a larger sample, reflects the current business mix, and allows you to set the capital structure to the target rather than historical average.

1. Identify comparable firms in the same industry (15-20 minimum).
2. Find their equity betas, unlever each using its own D/E and tax rate.
3. Take the median unlevered beta.
4. Relever at the target company's D/E ratio and marginal tax rate.

See [resources/methodology.md](resources/methodology.md#bottom-up-beta-estimation) for the complete procedure and the relevering formula.

**Step 4: Compute cost of equity**

Apply the CAPM formula. For emerging market companies, incorporate the country risk premium into the expected return calculation. See [resources/template.md](resources/template.md#cost-of-equity-calculation) for the calculation worksheet.

**Step 5: Compute cost of debt via synthetic rating**

Estimate what rating the company would receive based on its interest coverage ratio, then look up the corresponding default spread.

1. Compute interest coverage = EBIT / Interest Expense.
2. Map to a synthetic rating using the lookup table (separate tables for large and small firms).
3. Cost of debt = Riskfree rate + Default spread for that rating.
4. After-tax cost of debt = Cost of debt x (1 - Marginal tax rate).

See [resources/methodology.md](resources/methodology.md#synthetic-rating-table) for the complete interest-coverage-to-rating-to-spread lookup table.

**Step 6: Compute WACC and validate**

Combine cost of equity and after-tax cost of debt using market value weights.

See [resources/template.md](resources/template.md#wacc-computation-worksheet) for the complete worksheet. Validate using [resources/evaluators/rubric_cost_of_capital_estimator.json](resources/evaluators/rubric_cost_of_capital_estimator.json). Minimum standard: Average score of 3.5 or higher.

## Common Patterns

**Pattern 1: US / Developed Market Company**

- **Riskfree rate**: US 10-year Treasury yield (or equivalent government bond in the analysis currency).
- **ERP**: Implied mature market premium only (no country risk premium).
- **Beta**: Regression beta available from financial data providers; bottom-up beta still preferred for stability.
- **Cost of debt**: Actual credit rating from Moody's/S&P if available; synthetic rating as cross-check.
- **Simplifications**: No currency conversion needed, no CRP weighting, no inflation differential.
- **When**: Large-cap US/European/Japanese companies with primarily domestic operations.

**Pattern 2: Emerging Market Company**

- **Riskfree rate**: Derived from local government bond minus sovereign default spread, or built from US riskfree rate plus inflation differential.
- **ERP**: Mature market premium + operation-weighted country risk premium.
- **Beta**: Bottom-up from global industry peers (emerging market betas from regression are noisy due to thin trading).
- **Cost of debt**: Synthetic rating preferred (local credit ratings may not be comparable).
- **Key decisions**: Currency of analysis, CRP weighting method, whether to add country risk to cost of debt or only to cost of equity.
- **When**: Companies incorporated in or with significant operations in Brazil, India, China, South Africa, Turkey, etc.

**Pattern 3: Private Company**

- **Riskfree rate**: Same as public company in same currency.
- **ERP**: Same as public company in same geography.
- **Beta**: Bottom-up from public peers, but consider total beta adjustment if the owner is undiversified. Total beta = market beta / correlation with market, resulting in a higher cost of equity.
- **Cost of debt**: Synthetic rating using the small-firm lookup table (tighter interest coverage thresholds).
- **Key decision**: Is the buyer/owner diversified (use market beta) or undiversified (use total beta)?
- **When**: Private companies, PE-owned firms, family businesses, startups.

**Pattern 4: Multi-Division Conglomerate**

- **Approach**: Estimate