Cost of Capital and Capital Structure - Study Guide
This domain tests the minimum return a firm must earn and how debt–equity mix affects it. Expect WACC calculations, component costs, weights, and basic capital-structure reasoning.
Core ideas
- WACC = wd × kd(1 − t) + wp × kp + we × ke, where weights are based on market values where possible.
- Cost of debt is the yield or effective interest rate, adjusted for tax because interest is deductible.
- Cost of equity can be estimated by CAPM: ke = risk-free rate + beta × market risk premium, or by dividend growth.
- Preference capital has a fixed dividend but no tax shield.
- Retained earnings are equity funds; their cost is the shareholders' required return.
- Capital structure trade-off: debt adds a tax shield but increases financial distress and agency costs. Modigliani–Miller with taxes suggests value rises with debt, but real-world costs offset this.
Worked example
A firm has 40% debt and 60% equity by market value. Pre-tax cost of debt is 10%; tax rate is 25%; cost of equity is 14%. After-tax cost of debt = 10% × (1 − 0.25) = 7.5%. WACC = 0.40 × 7.5% + 0.60 × 14% = 3.0% + 8.4% = 11.4%. The reasoning: each rupee of capital is weighted by its share, and only debt gets the tax adjustment.
Traps
Do not use the coupon rate as cost of debt if the bond trades at a premium or discount; use yield. Do not forget the tax shield. Do not use book weights when market weights are available and materially different. Do not add flotation costs to the discount rate incorrectly; adjust the component cost or cash flows consistently.