Cost of Capital
Cost of Capital
The exam tests computing each component cost and combining them into the weighted average cost of capital (WACC), plus choosing appropriate weights and discount rates.
Component costs
- Debt: after-tax cost = YTM × (1 − T). Use the current market yield, not the coupon rate.
- Preferred: rp = Dp/net proceeds per share, where net proceeds deduct flotation costs.
- Equity via CAPM: re = rf + β(rm − rf), where (rm − rf) is the market risk premium.
- Equity via dividend growth: re = D1/P0 + g.
- Bond-yield-plus-risk-premium: re = bond YTM + judgment premium.
- WACC = wd × rd(1 − T) + wp × rp + we × re, with weights at market value (or target weights).
- The marginal cost of capital rises once retained earnings are exhausted; the break point is retained earnings divided by the equity weight.
- Flotation costs can be handled by using net proceeds or by adding to the initial outlay of the specific project.
Worked example
Target capital structure: 40% debt at 7% pretax, 10% preferred at 8%, and 50% common equity at 12%; the tax rate is 30%. After-tax debt = 7% × 0.70 = 4.9%. Weighted components: 0.40 × 4.9% = 1.96%; 0.10 × 8% = 0.80%; 0.50 × 12% = 6.00%. WACC = 1.96 + 0.80 + 6.00 = 8.76%. An average-risk project with an expected return above 8.76% adds value; a project in a riskier line of business should be discounted at a higher rate.
Traps
- Forgetting the debt tax shield and using 7% instead of 4.9%.
- Using the coupon rate rather than the YTM when the bond trades away from par.
- Weighting with book values, which typically understates the equity weight for mature firms.
- Applying the firm-wide WACC to a project with a different risk profile.
- Treating flotation costs as a recurring annual cost instead of a one-time adjustment.