Cost of Capital and Gearing Decisions
WACC and gearing
Cost of capital is the discount rate for investment and valuation. SL2 tests CAPM, dividend growth, bond yields, WACC, asset and equity beta, and the effect of gearing.
Core rules
- Ke = Rf + beta-e(Rm - Rf); or Gordon: Ke = D1/P0 + g.
- Kd should be the market yield to maturity, and after tax: Kd(1 - T).
- WACC = E/V times Ke plus D/V times Kd(1 - T), using market values.
- To compare projects, ungear comparable-company beta: beta-a = beta-e[E/(E + D(1 - T))], then regear at the target structure.
- Use a project-specific rate when the project's risk differs from the firm's existing business.
Worked example
Equity market value LKR 60m, debt LKR 40m, Ke 14%, pre-tax Kd 9%, tax 30%. WACC = 0.6 times 14% plus 0.4 times 9% times 0.7 = 8.4% plus 2.52% = 10.92%. A project with the same risk should be accepted only if its return exceeds 10.92%. If the project is in a riskier industry, using 10.92% would overstate NPV; regear a proxy asset beta and recalculate.
Traps
Do not use the coupon rate when the bond's market yield is available; do not mix book and market weights; do not forget the tax shield on debt; and do not use the firm-wide WACC for a dissimilar project.