Cost of Capital: Advanced Topics

Introduction

A company’s weighted average cost of capital (WACC) represents the cost of debt and equity capital used by the company to finance its assets. The cost of debt is the after-tax cost to the issuer of debt, based on the return that debt investors require to finance a company. The cost of equity represents the return that equity investors require to own a company, also referred to as the required rate of return on equity or the required return on equity.

A company’s WACC is used by the company’s internal decision makers to evaluate capital investments. For analysts and investors, it is a critical input used in company valuation. Equation (1) shows how a company’s WACC is driven by the proportions, or weights (the w_i), of the different capital sources used in its capital structure, applied to the costs of each source (the r_i ):

WACC = w_dr_d(1 – t) + w_pr_p + w_er_e,                                                                                              

where d, p, and e denote debt, preferred equity, and common equity, respectively. These weights are all non-negative and sum to 1.0.

Determining a company’s WACC is an important, albeit challenging, task for an analyst given the following:

• Many different methods can be used to calculate the costs of each source of capital; there is no single, “right” method.
• Assumptions are needed regarding long-term target capital structure, which might or might not be the current capital structure.
• The company’s marginal tax rate must be estimated and might be different from its average or effective tax rate.

Estimating the cost of capital for a company thus involves numerous, sometimes complex, assumptions and choices, all of which affect the resulting investment conclusion.

The member should be able to:

• explain top-down and bottom-up factors that impact the cost of capital,
• compare methods used to estimate the cost of debt,
• explain historical and forward-looking approaches to estimating an equity risk premium,
• compare methods used to estimate the required return on equity,
• estimate the cost of debt or required return on equity for a public company and a private company, and
• evaluate a company’s capital structure and cost of capital relative to peers.