An entity's capital structure is its mix of debt, preferred stock and common equity supporting its assets and operations. Financing choices allocate operating cash flows among investors with different payment priorities, contractual rights and exposure to losses.
The cost of capital is the return capital providers require for bearing the risk of supplying funds. Analysts calculate the cost of capital using current component costs and the capital weights specified for the decision.
The weighted-average cost of capital (WACC) combines those component costs into one annual required return. Its use assumes the evaluated operations have risk, currency and financing characteristics consistent with the estimated rate.
Market-value weights measure each funding source relative to total market capital. Explicit target weights represent the intended financing mix and take precedence when the scenario requires them.
To calculate the cost of capital, common equity includes the market value of outstanding shares, including value supported by retained earnings. Retained earnings are not added again as a separate market-value component.
Common mistakes
- Using the old coupon. Harbor's historical coupon produces 40% x 4.5% + 10% x 8% + 50% x 11.2% = 8.20%, understating its supported WACC.
- Shielding every component. Applying 75% to Harbor's pretax weighted total gives (40% x 8% + 10% x 8% + 50% x 11.2%) x 75% = 7.20%; equity returns are incorrectly reduced.
- Using the just-paid dividend. Harbor's $3 / $50 + 6% = 12.00% omits dividend growth before the expected-dividend yield, instead of producing 12.36%.
Bottom line
- WACC uses current component costs and stated target or market-value weights that sum to one.
- Eligible debt cost receives one supported tax adjustment; preferred dividends and common-equity returns do not receive an interest tax shield.
- Equity-cost methods require their own supported inputs, and retained earnings carry an opportunity cost.
- Financing changes require new weights, relevant component costs, cash-use assumptions and separate covenant and liquidity tests.
Exam shortcut
Identify the requested decision first: a component cost, total WACC, a covenant result or a financing recommendation. Select the corresponding inputs before doing arithmetic. Mark market yields, target weights, just-paid dividends, net proceeds and annual compounding conventions. Each signal changes a specific numerator, denominator or rate. Draw the cash use after a financing transaction. Retained proceeds, equipment purchases, debt repayments and repurchases produce different liquidity results.
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Learning objectives
- I.B2
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