Financing Decisions and Cost of Capital
What you must understand
You must compute the weighted average cost of capital, the cost of equity via CAPM and the dividend growth model, the cost of debt (including irredeemable and redeemable debt, and after-tax effects), and understand gearing - book versus market, and the impact of tax. Know the traditional and Modigliani–Miller views (with and without tax), the trade-off with financial distress costs, and the pecking order. Also cover dividend policy, share buybacks, rights issues and the choice between debt and equity.
Traps in questions
- Using book values when market values are available for WACC weights.
- Forgetting that debt interest is tax-deductible - the after-tax cost of debt is Kd(1 − t).
- Applying the dividend growth model when the payout ratio is unsustainable.
- Mixing up the asset beta (ungeared) and equity beta (geared); re-gear before using CAPM for a project.
- Ignoring issue costs and the dilution effect of a rights issue.
Worked rule of thumb
WACC = (E/V) × Ke + (D/V) × Kd(1 − t), using market values. For a redeemable bond, the cost of debt is the IRR of the after-tax cash flows (coupons net of tax plus redemption).
Example
Equity £60m at Ke 12%, debt £40m at pre-tax Kd 6%, tax 25%. WACC = 0.6 × 12% + 0.4 × 6% × 0.75 = 7.2% + 1.8% = 9.0%. If book values were used instead, the weights would misstate the true cost of capital.