How cost of capital drives valuation outcomes

Valuation outcomes rise and fall with the cost of capital. When capital is cheap, funding expands, leverage increases, and valuations rise. When capital becomes expensive, required returns rise and valuations fall.

• In a DCF, higher cost of debt and equity increase the discount rate, directly reducing the present value of future cash flows and therefore the implied valuation.

• In an LBO, higher interest rates raise the cost of debt and shrink the amount of leverage a buyer can use, directly reducing the entry valuation.

• In equity markets, valuation multiples and stock prices fall when risk-free yields rise, as investors demand higher returns from equities relative to safer alternatives like bonds — prices must decline to compensate for the higher risk and required reward

What is cost of capital?

Cost of capital is the blended return expected by both shareholders and lenders for providing funds to the business. It combines two components — the cost of equity and the cost of debt — weighted by how the company is financed. The formula, known as the Weighted Average Cost of Capital (WACC), is simple in structure but powerful in impact: it defines the minimum rate of return a company must generate to preserve its value.

The cost of equity reflects the return shareholders expect for taking on ownership risk — typically derived from models like CAPM or, more practically, benchmarked against market peers and perceived business risk.

The cost of debt represents the effective interest rate paid on borrowed funds, adjusted for tax deductibility.

Together, they capture the trade-off between risk and return: equity is more expensive because it carries residual risk, while debt is cheaper but adds leverage and financial pressure. The lower the blended cost of capital, the more valuable the business becomes — and vice versa.

Cost of capital in a DCF

In a DCF, the cost of capital reflects the return required by the buyer, not the target company’s historical financing structure. The discount rate is based on how the acquisition will actually be funded — either fully with equity or through a mix of debt and equity at the acquirer’s own cost levels. If the buyer finances the deal entirely with equity, the relevant rate is the cost of equity of the acquiring group. If the transaction involves acquisition financing, it becomes a blended rate of the group’s cost of equity and cost of debt, adjusted for the intended leverage. The discount rate is therefore an expression of the buyer’s opportunity cost of capital, not the target’s standalone structure.

In practice, the DCF is performed using the buyer’s target WACC, reflecting their return expectations, funding mix, and risk tolerance. A strategic buyer with low funding costs and strong credit can justify a lower discount rate — and therefore a higher valuation — for the same set of cash flows.

Ultimately, the cost of equity is an opportunity cost, not just a theoretical CAPM output. You can model an academically precise cost of equity, but if your capital can earn 10% elsewhere with similar risk, that becomes your real hurdle rate. In a DCF, valuation is always anchored to the return you could earn elsewhere, not what the formulas say in isolation.

LBO - Lower debt costs expand valuation capacity in an LBO

In an LBO, the cost of capital doesn’t appear as a single discount rate — it works through the interest expense on the debt. A lower cost of debt increases the amount of leverage a buyer can raise and therefore expands the headroom on valuation. If lenders are willing to fund more cheaply, the sponsor can put less equity into the deal, which increases the IRR with everything else held constant.

The result is simple: cheap debt lifts valuations, expensive debt compresses them. That’s why changes in monetary policy and credit-market interest rates directly influence private-equity valuations and risk appetite.

Valuation multiples already embed the market’s cost of capital

Cost of capital is not missing from multiples — it’s simply embedded in the prices investors accept as the market standard. When the cost of capital rises, the market responds by reducing EBITDA multiples. Both LBOs and DCF valuations decline as higher debt and equity costs drive lower enterprise values. Movements in valuation multiples are therefore a composite reflection of many factors, with the cost of capital acting as one of the most powerful forces behind them.

Though EBITDA multiples don't explicitly include capital structure, they move with both cost of equity and cost of debt. When interest rates rise, the risk-free rate increases, raising cost of equity (investors demand higher returns → stock prices fall) and cost of debt (borrowing becomes more expensive → buyers can pay less). Both effects cascade into lower EBITDA multiples across public and private markets. That’s why valuation levels across markets move in tandem with interest rates and credit spreads.

A capex-heavy business with low equity yields and limited dividend capacity carries a higher cost of equity, translating into lower multiples.

Conversely, when debt becomes cheaper — as in periods of low rates or loose credit — buyers can lever more aggressively and justify higher entry multiples.

Multiples effectively reverse-engineer the same logic a DCF or LBO makes explicit. Instead of discounting cash flows at a given rate, the market expresses its confidence as “I’m willing to pay X years of EBITDA for this business.” High multiples signal belief in stability, cash conversion, and predictable growth; low multiples reflect perceived volatility or financing risk. In this sense, every multiple implicitly contains the market’s view of cost of capital — it’s just hidden inside the number rather than written into a formula.

Where does it leave us?

Cost of capital ultimately defines how much investors are willing to pay for any target company — whether through a DCF, an LBO, or a market multiple. It connects macro conditions like interest rates and risk premiums with micro-level outcomes such as entry valuations, discount rates, and IRR targets.

When capital is cheap, valuations stretch, leverage expands, and even mediocre assets find buyers. When capital tightens, discipline returns, returns normalize, and both multiples and valuations compress.

In the end, valuation outcomes simply reflect the price of money. When required returns rise, everything reprices downward; when they fall, everything lifts. The models differ, but the mechanism is the same.