Cost of Capital and Capital Structure Decisions
What the domain tests
This domain tests computation and interpretation of component costs and WACC, CAPM, gearing effects and capital-structure theories. You must explain why the discount rate reflects risk and how financing choices affect firm value.
Core rules and concepts
- Cost of equity via CAPM: Ke = Rf + β(Rm − Rf). Dividend growth: Ke = D1/P0 + g, where D1 is next year's dividend.
- Cost of debt is the yield to maturity or effective interest rate, adjusted for tax: Kd(1 − t) because interest is tax-deductible where allowable.
- WACC = (E/V)Ke + (D/V)Kd(1 − t), using market values, not book values.
- Modigliani–Miller: without taxes and distress costs, capital structure does not affect value; with taxes, debt adds a shield; with distress and agency costs, an optimum trade-off may exist. Pecking order theory predicts internal funds first, then debt, then equity.
- Use a project-specific discount rate when the project's risk differs from the firm's existing portfolio.
Worked example
Equity market value N600m, debt N400m, Ke 18%, pre-tax Kd 10%, tax 30%. V = N1,000m. WACC = 0.6 × 18% + 0.4 × 10% × 0.7 = 10.8% + 2.8% = 13.6%. If the project is riskier than the firm, 13.6% is too low; a higher rate is needed. If flotation costs are 3% of new equity, the effective cost of new equity is higher than 18%.
Traps that cost marks
Do not use coupon rate instead of market yield; forget the tax shield; use book weights; apply the firm's WACC to a different-risk project; or claim MM implies debt is always better without distress costs. CAPM beta must reflect systematic risk, not total risk.