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HKICPA QP Module 7 Financial Management study materials
HKICPA QP Module 7 Financial Management study resources

HKICPA QP Module 7 Financial Management: Financing, Cost of Capital and Capital Structure

HKICPA QP Module 7 Financial Management · Work through your exam, one topic at a time.

All guide sections

Financing, Cost of Capital and Capital Structure

This domain tests how firms raise funds and how the cost of those funds affects investment decisions. The exam expects you to compute the weighted average cost of capital (WACC), estimate the cost of equity and debt, understand capital structure theories, and adjust discount rates for project risk. A common task is to ungear and regear betas for a project-specific cost of capital.

Core rules

  • Sources of finance include equity (rights issues, placements, IPOs), debt (bank loans, bonds) and hybrids (convertibles, preference shares). Choice depends on control, flexibility, covenants, issue costs and financial distress risk.
  • Cost of equity: CAPM Ke = Rf + beta x (Rm - Rf); or dividend valuation with Gordon growth, Ke = D1/P0 + g. Use a risk-free proxy, an equity risk premium and a beta relevant to the project.
  • Cost of debt is the yield to maturity, adjusted for tax: Kd(1 - t). Use market values, not book values, for WACC weights, and target gearing where appropriate.
  • WACC = (E/V)Ke + (D/V)Kd(1 - t). It is valid only for projects of similar business and financial risk to the firm.
  • Capital structure theories: Modigliani-Miller without tax says capital structure is irrelevant; with tax, debt creates a tax shield; the trade-off theory balances tax benefits against financial distress and agency costs; pecking order theory prefers internal funds, then debt, then equity.
  • For a project in a different industry, ungear the proxy beta, regear at the firm's target gearing, then use CAPM.

Worked example

A firm has equity market value $600m and debt market value $400m. Ke is 12%, pre-tax Kd is 6%, and tax is 16.5%. WACC = 0.6 x 12% + 0.4 x 6% x (1 - 0.165) = 7.2% + 2.004% = 9.204%, say 9.2%. Reasoning: debt is cheaper because interest is tax-deductible, but it increases financial risk. If evaluating a project in a different sector, this 9.2% is not appropriate; use a proxy asset beta and regear to the firm's target gearing to derive a project-specific rate.

Traps that cost marks

  • Using book values or coupon rates instead of market values and yields.
  • Forgetting the tax shield on debt.
  • Using the firm's WACC for all projects regardless of risk.
  • Applying Gordon growth with an unsustainable growth rate.
  • Ignoring issue costs or the effect of gearing changes.