Company A is considering paying THB 1,000,000 for future cash flows. Adding the three years of receipts is insufficient: we need a rate reflecting time and the return capital providers require. This episode constructs the 9.12% rate used in the learning case and explains why a correct weighted-average calculation can still be inappropriate for a particular project.
Every rate and weight below is hypothetical. None is a market quote, a recommended return for Thai SMEs, or a tax rule applying to every company. Cash flows and the discount rate are nominal annual baht measures on an after-tax basis. We assume the project’s operating risk is compatible with the illustrative cost of capital.
Cost of capital is not limited to interest expense in the accounts. Equity investors also require compensation for committing money and bearing risk, even when no scheduled dividend or interest invoice exists. Retained earnings remain shareholders’ funds with alternative uses; keeping money inside the company does not turn it into free capital.
Start with the risk borne by capital providers
Lenders assess repayment ability, contractual protection, collateral, and default risk. Equity holders receive the residual after other claims, so their exposure and required return differ. A deposit rate is not automatically an appropriate hurdle for a risky operating project. The comparison must reflect whose money is committed and which uncertainty the investor is being asked to bear.
A market-based equity estimate may start with a same-currency risk-free rate and assess market risk. The capital asset pricing model (CAPM), for example, combines beta, a measure of exposure to market risk, with an equity risk premium. Applying it to a private company requires defensible comparables and leverage assumptions. A formula does not create reliable inputs where market evidence is thin, and this episode does not pretend the illustrative 12% was estimated from observed Company A data.
For the exercise, take the equity cost as 12% and the pretax debt cost as 6%. In an actual decision, ask whether a debt rate reflects the cost of raising comparable new funding or merely the coupon on an old loan. Historical financing terms may not measure the opportunity cost of capital available today.
Define the weights before averaging
Assume a target operating capital structure of 60% equity and 40% debt measured at market values. These are not book-value weights. Nor does borrowing THB 400,000 against a THB 1,000,000 initial budget establish that debt will remain 40% of market value throughout the project. Financing amounts and valuation weights need to be distinguished.
Assume a 20% tax rate and that the interest deduction produces the modeled tax benefit. After-tax debt cost is 6% × (1 − 20%) = 4.8%. Actual tax treatment and the ability to use a deduction depend on the applicable circumstances. A loss-making business or a legal limitation can make a mechanically assumed tax shield inappropriate.
Weighted average cost of capital (WACC) is 60% × 12% + 40% × 6% × (1 − 20%) = 7.2% + 1.92% = 9.12% annually. There is no preferred stock in this exercise. The percentage is a required return used to compare compatible cash flows, not an additional cash invoice to deduct from the project’s forecast each year.
= 7.20%
= 1.92%
Identify the cash flow this rate belongs to
Our project cash is available to debt and equity capital providers before financing payments, so it is paired with a compatible overall cost of capital. Cash remaining specifically for equity after debt service is different and requires an appropriate equity return. Mixing the equity cash flow with WACC can distort value even when each number was calculated carefully.
Do not apply one company rate to every project without reviewing operating risk. Expanding an established service may differ substantially from entering an unproven technology business. Currency, inflation, timing, and tax basis must also align. The 9.12% is valid for our exercise because those compatibility assumptions are explicitly supplied, not because the company name appears on the proposal.
OpenStax explains capital-structure weights and the WACC equation. Use those readings to understand the inputs. Our rates, weights, and tax assumption are separate teaching choices, not the textbook company’s facts and not current market estimates for this fictional business.
Finish the rate review before asking the formula to decide
Exercise: if the debt tax benefit is unavailable but every other assumption stays unchanged, what is WACC? It becomes 60% × 12% + 40% × 6% = 9.6%. This is a separate sensitivity exercise, not a change to our canonical 9.12% base case. Do not deduct interest in project FCFF and then claim the same financing effect again through the rate.
If someone proposes 5% simply to obtain a positive NPV, return to the evidence. A discount rate is not a control for producing a preferred answer. Equally, using an unexplained very high rate does not prove sound caution. Record the estimation method, the date and currency of inputs, and the risk judgment so that a reviewer can challenge them.
Before calculating NPV, write one sentence identifying who receives the cash, its tax and currency basis, its timing, and why the selected required return is appropriate. That small discipline prevents a common failure: correct arithmetic comparing different financial claims. Episode 7 will use the frozen base cash flows and the frozen 9.12% rate, rather than adjust assumptions to fit the result.