Cost of Capital for a Private Apparel Factory: Build a Defensible Range

Begin with the decision the rate must support

A factory can borrow at an attractive rate and still make a poor investment. The loan price describes one source of funds. It does not measure the return that the whole investment should earn for lenders and owners.

This distinction matters when a private apparel business plans a new production unit. A bank quote is visible, while the owners' required return is harder to observe. Using the bank rate for the entire project treats equity like debt. It assumes that both carry the same risk and cost.

Cost of capital puts those claims on a common basis. It estimates the return required for committing funds to an activity with a given risk. Retained profits also belong to the owners. Reinvesting them has an opportunity cost even when no new share certificate or interest invoice appears.

Damodaran's discussion of cost of capital treats the hurdle rate as an opportunity cost. It also warns against choosing a rate to produce a desired value. Start with the proposed factory activity and its risks. Then decide which percentage fits the appraisal.

The examples below are invented. CU means currency units. The rates, tax assumptions, company values and betas are teaching inputs. They are not current apparel-industry benchmarks. The aim is to build a range whose inputs can be challenged and improved.

Fix the cash-flow basis first

Write down what the cash flows represent before estimating their discount rate. A forecast for the whole business differs from a forecast of cash available only to shareholders.

In the first approach, project cash flows start with operating receipts. Deduct operating costs, operating taxes and the required investment. They exclude new borrowing, loan principal repayments and interest payments. A suitable weighted average cost of capital, or WACC, can then discount those flows.

An equity forecast follows a different route. It includes the relevant debt cash flows and is discounted at the cost of equity. Damodaran's private-company valuation notes make this distinction between business value and equity value. Mixing the two approaches can count financing twice or omit it.

For this guide, the example uses annual nominal cash flows in one currency, after operating tax and before financing. The target financing proportions are assumed to remain suitable over the appraisal period. The model has only ordinary equity and conventional interest-bearing debt. There are no preferred shares or convertible instruments to treat separately.

A factory model should also state how it treats leases, supplier finance and operating payables. A payment may already sit in operating cash flow. Moving it to financing can require changes elsewhere in the model. Adding its balance to debt is only part of the task; review the related cash flow too.

The cash budget remains separate. It must show actual repayment dates and funding gaps even when the investment appraisal uses a blended annual rate. A positive project value does not put money in the bank before wages fall due.

Calculate a transparent starting WACC

For the simple financing structure used here:

WACC = [E ÷ (D + E)] × Ke + [D ÷ (D + E)] × Kd × (1 − T).

E is the estimated market value of ordinary equity. D is the estimated market value of debt. Ke is the required equity return, while Kd is the current pre-tax cost of debt. T represents the assumed usable tax relief on interest in this simplified calculation.

ACCA's capital-structure guidance explains market-value weighting. The weights describe the capital supporting the activity. They do not track which bank account paid each part of one machine invoice.

Suppose a factory's assumed financing values are CU 3 million of equity and CU 2 million of debt. Its supported target weights are therefore 60% equity and 40% debt. Start with an illustrative equity cost of 15%, a debt cost of 9% and full, immediate interest relief at 25%.

The after-tax debt component is:

9% × (1 − 0.25) = 6.75%.

The weighted components are:

Equity: 0.60 × 15% = 9.00 percentage points.

Debt: 0.40 × 6.75% = 2.70 percentage points.

Adding them gives WACC = 11.70%. The weights sum to one, and the result lies between the two component costs. These are useful arithmetic checks, although neither proves that the inputs are suitable.

The 2.70 figure is a contribution to the blended rate. It is not the bank's interest rate or a new tax rate. Likewise, 11.70% is not an annual cash bill charged on the factory's accounting assets.

Keep the unrounded inputs in the model. Two decimal places may help compare scenarios, but they do not imply that a private firm's required return is known that closely.

Explain where the private-company weights came from

A listed share price is not available for most private factories. The missing price creates an estimation problem. Replacing it with paid-up capital does not solve that problem.

Suppose the same factory reports only CU 1.2 million of book equity. Combining that number with CU 2 million of debt produces weights of 37.5% equity and 62.5% debt. If all component rates are held unchanged, the resulting calculation is:

0.375 × 15% + 0.625 × 6.75% = 9.84375%.

That lower answer comes from changing the measurement basis. No lender reduced its price and no operating risk was removed. It cannot be presented as evidence that the factory's true cost of capital fell.

A recent relevant sale of shares can help support a private equity value. A documented valuation can provide another basis. A transaction may need adjustment for different rights, control or conditions. Where the evidence is weak, a supported target capital structure can be more useful than a false claim of a precise market price.

The private-company valuation notes also identify a circularity. The estimated value depends on the discount rate. Yet value-based weights influence that same rate. If the model solves this by iteration, disclose its starting assumptions. Check the resulting debt proportion as well. A model using target weights should explain why the factory can maintain them.

Debt values need thought too. A loan's outstanding principal may be close to its value in some cases. It is not always the current market value. An old fixed-rate obligation can differ from an otherwise similar loan priced today. Record any approximation and its likely significance.

Use current debt evidence and a supportable tax benefit

Damodaran's cost-of-debt teaching notes define the input in terms of current borrowing conditions. Historical interest expense divided by last year's debt can miss changes in rates, credit quality and financing terms.

Start with dated lender terms for the factory. Match the currency, amount, maturity and security to the proposed borrowing. It should distinguish a firm offer from an indicative quote. Check whether a subsidy or shareholder guarantee supports the quote. Either may explain a price below ordinary borrowing terms.

Fees and repayment structure belong in the assessment of borrowing cost. The 9% example assumes a suitable annual cost with no omitted fee adjustment. It is not an instruction to use whichever percentage is most prominent in a term sheet.

Tax relief needs its own evidence. The 25% input here is hypothetical and does not state a tax rate for any country. Full, immediate relief is assumed only to make the first calculation clear.

Consider the UK as a specific example. HMRC's current guidance describes limits on corporation-tax deductions for interest and financing costs. Those rules concern UK companies and groups within their scope. They cannot be carried across to another factory's jurisdiction.

The local review should establish whether interest is deductible. It also needs to show how much relief the factory can use and when. Losses or limits on deductions may prevent full relief in the current period. A later benefit is also worth less today than the same benefit received now.

For a simple sensitivity, keep the 15% equity cost, 9% debt cost and 60:40 weights fixed. This time, assume no interest tax benefit. WACC becomes 12.60%, rather than 11.70%. The difference is 0.90 percentage points.

This isolates the tax-benefit input; it is not a full re-estimation of every risk and financing effect. If relief changes over time, model its timing explicitly with suitable finance advice. A single average tax percentage may hide the very issue the review needs to resolve.

Build the equity estimate from visible assumptions

An owner's preferred return is useful for a discussion, but it is not automatically a market-based equity cost. Nor does a low dividend payment show that equity is cheap. Owners can receive value through future distributions or growth in their interest in the business.

One common framework is the capital asset pricing model, or CAPM. ACCA's explanation of equity cost and gearing sets out its relationship:

Ke = risk-free rate + equity beta × equity risk premium.

The premium is the expected market return above the risk-free rate. Beta measures exposure to market movements within the model. It is not a percentage probability that the factory will fail, and it does not measure every production risk.

Using invented inputs of 4.5% for the risk-free rate, 7% for the equity risk premium and 1.5 for equity beta gives:

Ke = 4.5% + 1.5 × 7% = 15%.

This explains the starting equity cost. It does not validate those three inputs. A real analysis needs their dates, methods and economic basis.

The currency choice is especially easy to mishandle in an export business. Damodaran's risk-free-rate paper explains the need to match the rate to the cash-flow currency and nominal or real basis. The factory's location alone does not settle that choice.

A dollar invoice does not make all factory cash flows dollar cash flows. Wages, utilities and taxes may use another currency. The forecast must handle those exposures consistently before applying a discount rate. A lower foreign-currency rate cannot simply discount unchanged domestic-currency amounts. That mismatch does not create value.

The selected risk-free input also needs an appropriate time horizon and a review of default risk. A government yield containing default risk is not automatically a clean risk-free rate. Historical teaching examples explain the method. Their quoted rates are not current inputs.

Separate operating risk from the peers' borrowing

A private factory cannot estimate its own stock-return beta from a share price that does not exist. Comparable listed businesses can provide evidence. Their operations must be comparable; a shared industry label is not enough.

A fashion retailer that owns brands and stores may have a different risk profile from a contract sewing factory. Compare customer markets and order terms. Then examine fixed costs and production activities to see whether the match is useful. An analyst should explain why each peer belongs in the group.

ACCA's project-specific CAPM guide describes how to remove the peers' financial gearing. The next step applies the target financing structure. Under the simplifying assumption that debt beta is zero:

Asset beta = equity beta ÷ [1 + (1 − T) × D/E].

Target equity beta = asset beta × [1 + (1 − T) × target D/E].

Here D/E is debt divided by equity, using the relevant value basis. It is different from debt divided by total capital. Debt beta being zero is a modelling approximation; it does not mean a loan cannot default. Material debt risk requires a more suitable model.

Consider three invented peers, all with a 25% tax assumption:

For peer A, the factor is 1 + 0.75 × 0.50 = 1.375. Dividing 1.10 by that factor gives 0.80. The simple mean of the three asset betas is 1.00.

At the factory's target 40% debt and 60% equity, D/E is 0.40 ÷ 0.60 = 2/3. The target equity beta is therefore 1.00 × [1 + 0.75 × 2/3] = 1.50. This produces the 15% equity cost used above.

The table demonstrates the calculation rather than claiming three real firms are comparable. In practice, examine the dates, business mix and estimation quality. A peer should not be dropped merely because its beta makes the preferred project harder to approve.

Show a range before choosing a working rate

The peer example also gives a useful sensitivity. Keep the target gearing, risk-free rate, market premium, debt cost and tax assumption unchanged. Vary only the asset-beta estimate:

For the lower case, WACC is 0.60 × 12.90% + 0.40 × 6.75% = 10.44%. The higher case uses the same method. This is an assumption range, not a statistical confidence interval or an observed range for apparel factories.

Other inputs deserve separate tests. At the central weights, increasing Ke by one percentage point raises WACC by 0.60 percentage points. Increasing Kd by one percentage point raises it by 0.30 percentage points. That calculation retains the 25% interest-relief assumption.

These changes help direct the next research effort. If the equity estimate is weak, obtaining a slightly more precise bank fee may not resolve the main uncertainty. Conversely, a credible equity estimate cannot excuse using an expired loan quote.

Avoid combining every low input into a supposedly likely favourable case. Rates and risk assumptions can move together. A combined scenario should describe a plausible situation and explain why its inputs belong together.

Reprice the components when the financing mix changes

Suppose someone proposes increasing debt to 60% because debt appears cheaper. Holding the original 15% equity cost and 6.75% after-tax debt cost unchanged gives:

0.40 × 15% + 0.60 × 6.75% = 10.05%.

That calculation silently assumes the extra borrowing changes neither component price. It is not enough to establish a better financing plan. More fixed debt claims can increase the risk borne by shareholders, while lenders may also change their terms.

For a separate illustrative scenario, retain asset beta 1.00 and the same simplified gearing model. At 60% debt, D/E becomes 1.50. Equity beta rises to 2.125, giving Ke of 19.375% with the earlier market inputs.

Now assume the borrowing review supports a 12% debt cost at that structure. With the same full 25% relief assumption, WACC is:

0.40 × 19.375% + 0.60 × 12% × 0.75 = 13.15%.

The hypothetical result is higher than 11.70%, despite the larger debt share. It illustrates why a financing comparison must revisit prices and assumptions. It does not prove that a particular debt ratio is optimal.

The gearing approximation becomes less convincing where debt risk is substantial. Nor does the example establish that lenders would actually provide the extra money. Check whether the factory can service the debt and refinance when needed. Review any conditions that limit payments to owners.

State whose equity return the estimate represents

The market-beta approach assumes an investor perspective that may differ from the founder's. A founder may have most of their wealth and income tied to one factory. A broad investment portfolio can spread some of those risks.

Damodaran's private-company equity discussion addresses this issue. It describes total beta as one possible treatment of an undiversified owner. Its use depends on the investor perspective and the supporting assumptions. Private ownership alone does not justify adding a standard number of percentage points.

State whose return the decision paper estimates. It might represent a diversified investor, the existing owner or a proposed buyer. Each may approach the valuation from a different position. If these differ, show separate analyses with reasons. Averaging them would hide a disagreement about the question being answered.

Factory-specific concerns also need a clear home in the analysis. If a major customer's possible cancellation changes expected order cash flows, show that effect in the forecast. Do not leave optimistic receipts unchanged and expect an unexplained rate premium to fix them.

Consider an isolated future receipt of CU 100,000. Assume an 80% chance of full payment and a 20% chance of zero. The expected amount is CU 80,000. This is a probability-weighted amount, not guaranteed cash. A risk-adjusted discount rate may still be required; expected loss and compensation for bearing risk are distinct.

ApparelDiary's capacity-investment decision-tree guide explains how to make such branches visible. Record where each risk is treated so that an extra adjustment has a clear purpose.

Use the range to identify the decision's weak point

Consider a separate project costing CU 1 million now. Assume five year-end net operating cash receipts of CU 270,000. There is no later receipt, residual value or working-capital recovery. These are complete hypothetical cash flows on the earlier basis.

Discount those five receipts and subtract the initial cost. The table shows net present values, rounded to whole currency units:

The sign changes within the assumption range. Selecting 10.44% just because it produces a positive answer would conceal the uncertainty. Improve the evidence for both the rate and the project cash flows. Then examine whether changes to the design or commercial terms could improve the case.

Those receipts should be incremental cash, with production and demand assumptions that can be checked. A quoted CM price or allocated production cost is not automatically project cash flow. The garment-costing breakdown helps explain the costing inputs. The investment case still needs payment timing, tax and any additional investment.

Leave a reviewable record

A useful conclusion names the working rate, its range and the conditions that support them. Attach the input dates, peer choices, capital-value basis, lender evidence and tax review. Keep the formulas visible and label changed assumptions. Another person should be able to trace the result without guesswork.

Record unresolved issues beside their decision effect. An uncertain equity value, a short-lived loan offer and delayed tax relief are different problems. Each calls for different evidence, even when all three affect the same final percentage.

Review the estimate when a material input changes. A new financing structure can make an old rate unsuitable. Changed business activities or market conditions can have the same effect. The date on the previous approval does not establish that it still fits the next project.

The result should be a reasoned estimate that the factory can explain. Clear assumptions connect financing and operating risk to the investment choice. The record also shows which uncertainties need work before the factory commits its funds.

References

• Damodaran: The Cost of Capital—Misunderstood, Misestimated and Misused, 2022 teaching material.

• Damodaran: Private Company Valuation, teaching notes.

• ACCA: Optimum Capital Structure.

• Damodaran: Estimating the Cost of Debt, 2021 teaching slides.

• HMRC: Restriction on Corporation Tax Relief for Interest Deductions, UK guidance.

• ACCA: Cost of Capital, Gearing and CAPM.

• Damodaran: Estimating Risk-Free Rates.

• ACCA: The Capital Asset Pricing Model, Part 2.

• Damodaran: Estimating the Cost of Equity for a Private Company.