In the context of business valuation, particularly for closely held or small businesses, the Weighted Average Cost of Capital (WACC) and the Cost of Equity Capital (Ke) are fundamental elements of discounting future income streams. Although these two rates are often used interchangeably or confused in practice, they serve distinct purposes and reflect different risk and return assumptions, particularly when debt is involved in the capital structure.

This paper clarifies the conceptual differences between WACC and Ke, outlines how each is calculated, and explains why they are not equal when a business has debt. It also examines the implications for valuation practitioners, especially in SBA 7(a) loan transactions, where accurate assessments of risk-adjusted return are crucial.

Cost of Equity Capital

The Cost of Equity Capital represents the return that equity investors require to compensate for the risk of investing in the business. For closely held businesses, it is typically estimated using the Build-Up Method:

Ke = Rf + ERP + Size Premium + Industry Premium + Company-Specific Risk Premium

• Rf = Risk-free rate
• ERP = Equity risk premium for the market
• Size premium accounts for higher volatility in smaller firms
• Industry risk premium reflects sector-specific uncertainties
• Company-specific risk premium captures unique business risks (e.g., key person dependence, customer concentration)

This method is often preferred over the Capital Asset Pricing Model (CAPM) in small business valuations due to the lack of meaningful beta estimates for privately held companies.

Weighted Average Cost of Capital (WACC)

The WACC represents the average rate of return required by both equity investors and debt holders. It is used to discount enterprise-level cash flows, such as free cash flow:

WACC = (E/V) * Ke + (D/V) * Kd * (1 – T)

• E = Market value of equity
• D = Market value of debt
• V = E + D = Total enterprise value
• Kd = Cost of debt
• T = Marginal tax rate

Because interest on debt is tax-deductible, the cost of debt is reduced by the tax shield, which lowers the WACC compared to the cost of equity alone.

Why WACC ≠ Cost of Equity When There Is Debt

When a business has no debt, the capital structure consists entirely of equity, making WACC equal to Ke. However, when debt is present, the situation changes:

1. Debt is cheaper than equity: Lenders take lower risk and accept a lower return (Kd < Ke).
2. Interest tax shield: The tax-deductibility of interest reduces the effective cost of debt.
3. Weighted blending: Because WACC blends the cheaper cost of debt and more expensive cost of equity, it results in a lower average rate than Ke.

Example: If Ke = 18%, Kd = 8%, and the capital structure is 70% equity and 30% debt with a 25% tax rate:

WACC = (0.70 × 18%) + (0.30 × 8% × (1 – 0.25)) = 12.6% + 1.8% = 14.4%

Here, WACC is 14.4%, which is lower than the cost of equity at 18%.

Why the Cost of Equity Is Always Higher Than the Cost of Debt (and WACC)

The cost of equity is fundamentally higher than the cost of debt for several structural and risk-based reasons:

1. Risk Subordination: Equity holders are the residual claimants in the capital structure, last in line in liquidation.
2. No Guaranteed Payments: Unlike debt, equity has no fixed obligations or maturity.
3. Volatility of Returns: Equity returns are more variable than debt, increasing required returns.
4. Information Asymmetry and Control Risks: Equity investors bear greater risk in closely held businesses with limited transparency.
5. Debt Tax Shield: Interest expense reduces taxable income, making debt cheaper.
6. Leverage Effect: As debt increases, equity holders face greater risk, requiring higher returns.

Practical Challenges in Applying WACC and Ke

Valuation professionals face several challenges when applying WACC and Ke in SBA 7(a) valuations:

• Estimating Capital Structure: Determining the market value of equity and debt for small private companies is difficult due to limited market data, often requiring iterative calculations or assumptions.
• Subjectivity in Ke Inputs: The company-specific risk premium (CSRP) in the build-up method is subjective.
• Tax Rate Assumptions: Selecting an appropriate marginal tax rate for the WACC’s tax shield is complex, especially for pass-through entities like S-corps, where taxes are paid at the shareholder level.
• Misapplication Risk: Confusing WACC and Ke (e.g., using WACC to discount equity cash flows) can lead to significant valuation errors, impacting loan collateral assessments.

Implications for Valuation

Using the wrong discount rate can significantly misstate value:

• When projecting equity cash flows (e.g., after debt service), use Ke.
• When projecting enterprise cash flows (e.g., before interest), use WACC, then subtract debt to get equity value.

This distinction is especially critical in SBA 7(a) valuations, where misunderstanding capital structure mechanics can result in undercollateralized loans or mispriced transactions.

Conclusion

In valuations of privately held businesses, it is vital to understand that WACC and Ke are not interchangeable when debt is involved. The cost of equity reflects the higher risk and expected return for equity holders, while WACC reflects the blended cost of capital inclusive of debt’s relative cost advantage. The cost of equity will always be higher than the cost of debt—and therefore higher than WACC—due to its residual risk exposure, lack of repayment certainty, and subordination in the capital stack. Recognizing and correctly applying these distinctions, while addressing practical challenges, is essential for credible valuations, particularly in SBA lending, where risk-adjusted returns and capital structures must be clearly supported.