Cost of Capital: Advanced Topics
Refresher reading access
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.
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 than 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.
Learning Outcomes
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;
- evaluate a company’s capital structure and cost of capital relative to peers.
1.75 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.