Cost of Capital (CoC) is a theoretical concept. Arithmetically, CoC is the weighted average of the cost of debt and cost of equity. Cost of debt is straightforward – it is the interest a company pays on its loans. Cost of equity is much more nuanced.
In theory, cost of equity should be the return demanded by equity shareholders to provide capital to the company. But what is this return - where to find it or how to calculate?
The simple answer to this is – you can’t. Equity shareholders provided funds to the company when the company was formed – that might be many years or even decades ago. They would also have provided funds intermittently thereafter – if there was a Rights Issue, QIP or other such events. Equity shareholders also provide funds to the company every year through Retained Earnings, assuming the company is profit-making and does not pay out all its profits as dividend. In all such cases, equity shareholders have expectations of getting a minimum something in return. That is the cost of equity, but no one really knows what it is.
Cost of capital is also defined as the opportunity cost of money – what the capital provider can earn by investing the same money elsewhere, since that is the benchmark he will use before investing in this company. But once again, it is not possible to put a precise number to it.
In all this, you will notice that expectations of investors like you and me who buy and sell in the secondary market do not come into picture at all. Their investments do not directly impact the company in any way. Therefore I started by saying that Cost of Capital is a theoretical concept. IMHO, it has no direct relevance to us in our investing. One only needs to understand it conceptually. And for tangible calculations, better to focus on RoE and RoIC since Equity (Net Worth) and Invested Capital are available with precision.
I tried to search whether Saurabh Mukherjea has explained how he calculates Cost of Equity (I have not read his book) and came across this article. Here, he simply adds up the risk free rate of 8 % and a “risk premium” of 6.5 -7% to get a cost of capital of 15 %. Read the article – it explains his thinking quite clearly.