Capital Structure, Financing, and Cost of Capital
This domain tests whether you can build a defensible discount rate and reason about how much debt a company should carry, what each source costs, and what the mix does to value and covenants.
Core rules
- WACC = (E/V) × Ke + (D/V) × Kd × (1 − t), using market values at target weights and marginal, not historical, costs.
- CAPM: Ke = Rf + β × MRP. Levered beta = unlevered beta × [1 + (1 − t)(D/E)]. Unlever comparable-company betas, then relever to the target structure.
- M&M without taxes: capital structure is irrelevant. With taxes: firm value rises by t × D, implying all-debt financing. Trade-off theory adds financial distress and agency costs, producing an interior optimum. Pecking order ranks internal funds, then debt, then equity.
- Preferred shares: cost = dividend / net proceeds; dividends are not deductible, so the after-tax cost exceeds debt of the same yield.
- Flotation costs reduce net proceeds and raise the effective cost of new external capital.
Worked example
Target D/E = 0.6, tax 25%, Rf 3.5%, MRP 5.5%, pre-tax Kd 6%, asset beta 0.90. Levered beta = 0.90 × [1 + (1 − 0.25)(0.60)] = 0.90 × 1.45 = 1.305. Ke = 3.5% + 1.305 × 5.5% = 10.68%. With D = 0.6E, V = 1.6E, so D/V = 37.5% and E/V = 62.5%. WACC = 0.625 × 10.68% + 0.375 × 6% × 0.75 = 6.68% + 1.69% = 8.37%. Use 8.37% for an average-risk project; a higher-risk project needs a rate built from its own unlevered beta.
Traps that cost marks
- Weighting with book values, or using the current structure when a target structure was specified.
- Forgetting the interest tax shield, or applying it to preferred dividends.
- Relevering with D/E when the question actually gives D/V - the two differ materially above low leverage.
- Pairing a current risk-free rate with a stale historical market risk premium without acknowledging the mismatch.
- Treating the coupon on existing debt as the marginal cost of new debt.