Capital Structure | Free CPA BAR Lesson

A finance director is choosing between funding a $40 million expansion with a 6% bond issue or a fresh equity raise. The CFO says debt is "cheaper" because interest is tax-deductible. The board worries about covenants. The exam question is not which choice is right, it is whether you can lay out the cost of capital, the leverage tradeoffs, and the optimal mix using the same framework the AICPA tests.

HIGH-FREQUENCY: WACC is the blended required return across every capital source. The exam tests the formula directly:

$WACC = w_{d} \cdot k_{d} (1 - T) + w_{p} \cdot k_{p} + w_{e} \cdot k_{e}$

The weights ( $w_{d}, w_{p}, w_{e}$ ) must sum to 1.0. Use market value weights, not book: the cost of capital is forward-looking and reflects what investors require today, not what was recorded at issuance. The exam will offer book-value weights as a distractor.

Tax adjustment is applied only to debt. Preferred dividends are paid from after-tax earnings; equity returns are not deductible. So only $k_{d}$ gets the $(1 - T)$ multiplier.

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Common mistakes

Using book-value weights for WACC. Book values reflect historical issuance, not what investors require today. The exam consistently uses market values. If only book values are given and the question asks for the cost of capital, the trap answer applies the book weights directly. The correct approach is to flag that market weights are required.
Forgetting the tax adjustment on debt, or applying it to preferred. Only interest on debt is tax-deductible. Preferred dividends are paid from after-tax earnings and get no shield. The exam often offers a WACC calculation with the tax adjustment misapplied: to preferred, to all components, or to none. Apply $(1 - T)$ only to $k_{d}$ .
Using the coupon rate as the cost of debt. The cost of debt is the current yield to maturity on the firm's outstanding bonds, not the coupon rate. Coupons are historical contractual rates; yield to maturity (YTM) reflects what investors require to hold the bond today.

Bottom line

WACC is the weighted average of after-tax cost of debt, cost of preferred, and cost of equity, computed at market value weights.
After-tax cost of debt equals pre-tax yield times (1 − T); the tax shield applies only to debt, never to preferred dividends.
Cost of equity has three accepted BAR methods: CAPM (rf + β × MRP), DDM (D1/P0 + g), and the build-up method.
M&M without taxes: capital structure is irrelevant. With taxes: $V_{L} = V_{U} + T \times D$ , so debt adds value through the interest tax shield.

Exam shortcut

When a question gives both book and market value capital amounts, always use market values for WACC weights. Book-value weights are a distractor. If the question gives only book values, flag the limitation: the cost of capital is forward-looking.

The full lesson (about 5,016 words, 33 min read) adds 9 worked examples, all 5 common mistakes, a self-check, free in the app.

Learning objectives

I.B2

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