Cost of Capital Structure WACC, MCC | Corporate Finance | Part 2 | Section B | Episode 16 | CMA USA

Welcome back to CMA USA exam coach your trusted study companion on the journey to mastering the CMA exam. In our previous episode we covered the key components of equity. We hope you practiced the concepts and reinforced your understanding with your textbook and question bank. Now in this brand new episode we are stepping into an extremely important topic for the CMA exam This concept is at the heart of financial decision making. It impacts the company's risk, its return to investors and ultimately its valuation. Let's begin by understanding what exactly is capital structure. Capital structure refers to the way a company finances its overall operations and growth by using different sources of funds. In simple terms it is the mixture of These sources typically include debt such as long-term loans and bonds, preference shares which offer fixed dividends and have priority over common shareholders, common shares the equity capital provided by the ordinary shareholders and other long-term funding instruments or retained earnings. So when we say capital structure we are talking about how much of the company's funding comes from debt, how much from equity and how they are combined. This combination is critical because it directly affects the company's risk profile, its return on equity and the cost of financing. A well-balanced capital structure helps a company maximize its value and minimize its overall cost of capital. In short capital structure is the financial backbone of a company's long-term stability and performance. Capital structure refers to the mix of long-term sources of funds that a company uses to finance its operations, expansion and most importantly its assets. Let's now understand why capital structure is so important for a business. Capital structure is not just a financial arrangement, it directly impacts a company's financial health, growth potential and risk profile. Let's explore the key reasons in detail. One, financial leverage and control. Capital structure determines how much debt a company can take on. Using debt in moderation can create financial leverage which means a company can boost its return on equity by using borrowed funds to grow faster. But too much debt increases risk. That's why finding the right balance between debt and equity is critical. Two, cost of capital optimization. Every source of capital has a cost, debt has interest costs and equity demands a return to shareholders. A well-planned capital structure helps minimize the company's overall cost of capital known as the weighted average cost of capital, WAC. Lower WACC means higher valuation and profitability. Three, maintaining debt to equity ratios. Lenders and investors often look at a If the ratio is too high it signals high risk and the company may struggle to get new loans or attract investors. So maintaining a healthy capital structure is essential to meet lending covenants and maintain credibility. Four, flexibility in financing future projects. A strong capital structure gives the company the flexibility to raise additional funds either through new equity or additional debt when a new opportunity or expansion arises. Companies with poor capital structures may miss growth opportunities due to funding constraints. Five, risk management and business stability. A balanced capital structure helps companies withstand economic downturns. Too much reliance on debt can lead to financial distress during low revenue periods. A good structure protects the company in both good and bad times. Six, impact on shareholder value. The way a company finances itself affects shareholder returns. A poorly planned capital structure can dilute earnings, reduce dividends or signal financial weakness whereas a well-planned structure enhances shareholder wealth in the long term. Now that we understand capital structure let's move forward and learn about a very important concept, cost of capital. What is cost of capital? Cost of capital is the rate of return that a company needs to earn on its investments to satisfy all its capital providers such as debt holders, preferred shareholders and common shareholders. In simple terms it's the cost of using funds whether borrowed or invested to finance business activities. Capital structure tells us the proportion of funding and cost of capital tells us the price or return expectation of each type of fund. Now we don't just take an average, we calculate the cost of each component of capital separately and then combine them to find the total cost. There are two important measures used in CMA and corporate finance. One, ACC. Weighted average cost of capital, WACC, represents the average cost of capital a company incurs weighted according to the proportion of debt, preference shares and equity in the capital structure. It reflects the minimum return the company must earn to satisfy all providers of For example, if debt is 40% of total capital and costs 6% and equity is 60% and costs 10%, then the WACC would be a weighted average of these rates. We will calculate WACC in detail in the next few slides. Two, MCC. Marginal cost of capital. Marginal cost of capital is the cost of obtaining one additional dollar of new capital. It is used when the company is planning new investment projects and wants to know what the next round of financing will cost. MCC helps in decision making by comparing it to the return from new projects. If the return on a project is greater than the MCC, it adds value to the company. So in summary, WACC equals average cost of capital already raised. MCC equals cost of raising new or additional capital. We will see how both are calculated and used in investment decisions. Before we move ahead with calculating WACC and MCC, let's take a moment to revisit the key formulas we learned in our previous episodes. These are the formulas for calculating the cost of individual capital components, such as the cost of debt, the cost of preference shares and the cost of common equity or retained earnings. You need to be clear about these formulas because we will be plugging them into the WACC and MCC calculations directly. So here's a quick recap. If you're unsure about any of these, go back and re-watch our earlier episodes to build a strong foundation. Let's now take a detailed look at an example to understand how we calculate the weighted average cost of capital or UACC. In this scenario, we are analyzing the capital structure of a company, which we will refer to as company A. We are given both the book values and market-based information for each capital component. Our goal is to calculate the WACC using market values and the cost of each capital component. To begin, let's first understand the capital structure of company A based on the book values. The company has issued $10 million in debt, $3 million in preference shares, $5.5 million in common stock and has accumulated $12 million in retained earnings. Altogether, this adds up to a total capital base of $30.5 million. However, it is crucial to note that when calculating WACC, we do not rely on book values. Instead, we calculate WACC based on the current market values of each financing source. Let's now go through the individual capital components, starting with the debt. Company A has issued 10,000 bonds, each with a face value of $1,000. These bonds carry a coupon rate of 4.09%, and the interest is paid semi-annually. The bonds were issued five years ago at par, meaning each bond was sold for $1,000, and they have a total maturity of 10 years. So now, they have five years remaining until maturity. In the current market, however, these bonds are trading at $960 each. This means they are trading at a discount. The prevailing market interest rate for similar bonds is 5%. Also, the company is subject to a corporate tax rate of 35%, which will reduce the effective cost of debt due to the tax shield benefit. This tax adjustment is applied only to debt, not to equity or preference shares. Now, let's move on to preference shares. Company A has issued 120,000 preference shares, each with a par value of $25. These shares are currently trading in the market at $25.5. The dividend rate on these shares is 4%, meaning each shareholder receives $1 as an annual dividend. The preference shares are clearly stated to be non-cumulative, but for WACC purposes, we still consider the fixed annual dividend to determine the cost of preference capital. The cost is calculated as the annual dividend divided by the current market price of each preference share. Finally, let's look at the common equity. The company has issued 578,000 common shares, each with a par value of $1. These shares are currently trading at $30 each. The most recent dividend paid was $1.25 per share, and this dividend is expected to grow consistently at 4% per year. Because we are given the current dividend and the expected growth rate, we will use the dividend discount model, also known as the Gordon growth model, to calculate the cost of equity. This model takes into account the expected future dividend, the current share price, and the expected growth rate. Now that we have identified all the components, debt, preference shares, and common equity, and we have their market values and associated costs, we are ready to move into the calculations. In the next step, we'll calculate the market value of each capital component, determine the specific cost of each, and then apply the weighted average formula to calculate the WACC for company A. Let's continue to the next part where we break down the cost of debt, the cost of preference shares, and the cost of equity, followed by the final computation of the company's weighted average cost of capital. Let's now take a closer look at the first component in the weighted average cost of capital, and that is the cost of debt. In our case, company A has issued bonds as part of its long-term financing. So the first step is to understand exactly how these bonds are structured, and then determine their cost from the company's perspective. According to the given data, company A has issued 10,000 bonds, each with a face value of $1,000. These bonds carry a coupon rate of 4.09%, and the interest is payable semi-annually. The bonds were issued five years ago with a total term of 10 years, which means they now have five years remaining until maturity. When the bonds were first sold, they were issued at par, meaning they were sold at their face value, $1,000 per bond. However, in the current market, these bonds are trading at $960, indicating that their value has decreased, and they are now trading at a discount. That's important because when the market value of the bond drops below its face value, it affects the cost of debt for the company. Now here's the key point. To calculate the cost of debt, we do not use the original coupon rate. Instead, we base our calculation on the current market conditions, which reflect the market required rate of return on debt of similar risk. And according to the question, the current market interest rate is 5%. That means if the company were to issue the same type of bond today, it would have to offer a return of 5% to investors. So for the purpose of our WACC calculation, the cost of debt before tax is considered to be 5%. However, as a business, the company gets a tax benefit for paying interest on debt. Interest expense is tax deductible, which effectively reduces the company's actual cost of borrowing. This is known as the tax shield on debt. To calculate the after-tax cost of debt, we apply the following formula. Cost of debt, denoted as CD, equals the market interest rate multiplied by 1 minus the tax rate. In this case, the market interest rate is 5%, and the effective tax rate is 35%. Plugging in these values, we get CD equals 5% times 1 minus 35%. That is, CD equals 5% multiplied by 1 minus 0.35, which gives us an after-tax cost of debt of 3.25%. So now we have our first component of WACC fully calculated. The cost of debt for company A is 3.25%. We'll use this number when we calculate the weighted average in the final step. But before that, let's move on to the next component, the cost of preference shares, which we'll calculate in the upcoming slide. The next step in calculating the weighted average cost of capital is to determine the cost of preference shares, which is represented as CPS. Let's start by understanding what's provided in the question. The company has issued a total of 120,000 preference shares. Each share has a par value of $25. However, these shares are currently trading in the market at a slightly higher price, $25.50 per share. This is important because for the purpose of calculating the cost of capital, we always use the current market price, not the par value. The dividend rate on these preference shares is 4% per year. That means each year, the company is expected to pay 4% of the par value as dividend to the preference shareholders. Also, it is mentioned that the preference shares are non-cumulative. This simply means that if the company misses a dividend payment in a given year, it is not obligated to make it up in future years. But from a calculation standpoint, whether the shares are cumulative or non-cumulative does not change our formula. We are still going to calculate the cost based on the annual dividend and the market price. So now, let's recall the formula for the cost of preference shares. CPS is equal to the annual dividend divided by the current market price of the preference shares. Let's calculate the annual dividend first. Since the par value of each share is $25 and the dividend rate is 4%, we calculate. Annual dividend is equal to $25 multiplied by 4%, which is equal to $1 per share. Now, we divide this annual dividend by the market price to get the cost of preference capital. So, CPS is equal to $1 divided by $25.50. That gives us approximately 0.0392. When we convert that into a percentage, we get 3.92%. Therefore, the cost of preference share capital, or CPS for this company, is 3.92%. That completes the second component of the weighted average cost of capital. Next, we will move on to the cost of common equity. Let's move on to the third and final component of our weighted average cost of capital, the cost of equity, denoted as CRE. To calculate the cost of equity, we are given the following information in the question. The company has 578,000 common shares outstanding. Each share has a par value of $1, but as with preference shares, we focus on the market value, not the par value. The current market price per share is $30. The last dividend paid by the company was $1.25 per share. This dividend is expected to grow by 4% every year indefinitely. This is a classic case where we apply the dividend discount model, also known as the Gordon growth model, to estimate the cost of equity. Now, let's recall the formula. The formula for cost of equity is CRE is equal to the next year's dividend divided by the current market price plus the expected dividend growth rate. Let's break it down step by step. First, we calculate the next year's dividend. Since the last dividend was $1.25 and the growth rate is 4%, we increase the dividend by 4% to estimate the next year's dividend. So, next year's dividend is equal to $1.25 multiplied by 1 plus 0.04, which gives us $1.30. Now, we divide this next year's dividend by the current market price, that is $1.30 divided by $30, which gives us 0.0433 or 4.33%. Finally, we add the expected growth rate of 4%. So, the cost of equity equals 4.33% plus 4%, which gives us a total of 8.33%. Rounding off, we can say the cost of equity is approximately 8.3%. This represents the return that common equity investors expect from the company based on the market price and expected dividend growth. And with that, we've now calculated all three components of the weighted average cost of capital, the cost of debt, the cost of preference shares, and the cost of equity. Now that we've calculated the cost of each capital component, let's begin the next stage of our weighted average cost of capital calculation, which is to find the market value of each component. Remember, when we calculate WACC, we use market values, not book values, because market values represent the actual cost of raising capital today. We'll start with debt, in this case, bonds. From the question, we are told that the company has issued 10,000 bonds, each with a face value of $1,000. However, the current market value of each bond is not $1,000. It has changed over time and is now $960 per bond. So, to find the total market value of debt, we simply multiply. 10,000 bonds multiplied by $960 per bond. This equals $9,600,000. That means, although the original book value of debt was $10 million, the market currently values it slightly lower, at $9.6 million. And that's the figure we will use as the market value of debt when calculating our WACC. Now let's move to the next component in the capital structure, preference shares. From the information provided, we know the company has issued 120,000 preference shares. Each preference share has a par value of $25. But when we calculate the weighted average cost of capital, we are interested in the market value, not the par value. So, what's the market price of each preference share today? It is $25.50 per share. To find the total market value of preference shares, we multiply. 120,000 shares multiplied by $25.50 per share. This equals $3,060,000. So even though the book value may have been different, we will now consider $3,060,000 as the actual market value of preference capital for our WACC calculation. Now, let's calculate the market value of the common shares. From the question, we are told that the company has issued 578,000 common shares. Each of these shares has a par value of $1. But as we discussed earlier, when calculating the weighted average cost of capital, or WACC, we use the current market price, not the par value. The current market price of each share is $30. So, to calculate the total market value of common shares, we multiply. 578,000 shares multiplied by $30 per share. This gives us $17,340,000. So the market value of the common equity portion of the capital structure is $17,340,000. This value includes both the common stock and retained earnings, because in market value terms, they are not separately identified. They are all reflected in the total equity market capitalization. In the next slide, we'll summarize all the market values of debt, preference shares, and common equity, and proceed to calculate the weightage of each for WACC. Now that we've calculated the market value of each source of capital, debt, preference shares, and common equity, the next step is to find the total capital based on market values, and then calculate the proportion or percentage each source represents in the overall capital structure. Let's start by recalling the market values for each. The market value of debt, or bonds, was $9,600,000. The market value of preference shares was $3,060,000. And the market value of common shares was $17,340,000. To find the total capital, we simply add all three components together. That is $9,600,000 plus $3,060,000 plus $17,340,000. This gives us a total capital of exactly $30,000,000. Next, we calculate the weight or proportion of each component by dividing the market value of each source by the total capital. Starting with debt, we divide $9,600,000 by $30,000,000. This gives us 0.32, or 32%. So, the weight of debt in the capital structure is 32%. Now for preference shares, we divide $3,060,000 by $30,000,000. This results in 0.102, which is approximately 10.2%. So, the weight of preference shares is 10.2%. Next, for common shares, we divide $17,340,000 by $30,000,000. That gives us 0.578, or 57.8%. So, the weight of common equity is 57.8%. At this stage, you may have noticed something important. In the book value capital structure, there was also a line item for retained earnings, which amounted to $12,000,000. So, why are we not including retained earnings in the WACC calculation? The answer is simple. Retained earnings are already included in the market value of common equity. They are a part of the company's own internally generated funds and do not require a separate cost to raise or finance. Since no new funds are being raised from retained earnings, and they are already contributing to shareholder equity, they do not have a distinct or additional cost like debt or preference shares. Therefore, we do not treat them as a separate source of capital for WACC purposes. We only consider external sources like debt, preference shares, and market value of common stock. Finally, let's also recall the specific cost rates we calculated for each component earlier. The after-tax cost of debt was 3.25%. The cost of preference shares was 3.92%. And the cost of common equity or retained earnings was 8.3%. Now that we have both the weights and the respective cost of each capital component, we are ready to move forward and calculate the weighted average cost of capital. Now that we've calculated the proportion or weight of each capital source and their respective costs, we are ready to calculate the weighted average cost of capital, commonly known as WACC. The formula for WACC is very straightforward. We multiply the weight of each capital component by its specific cost, and then we sum up the results. Let's begin with the data we already have. The weight of debt is 32% and the after-tax cost of debt is 3.25%. The weight of preference shares is 10.2% and their is 3.92%. The weight of common equity is 57.8% and the cost of equity is 8.3%. So the WACC formula becomes WACC equals 32% multiplied by 3.25% plus 10.2% multiplied by 3.92% plus 57.8% multiplied by 8.3%. After the calculation, the weighted average cost of capital for company A is 6.24%. This means the company, on average, pays 6.24 cents for every $1 of capital it uses, whether that capital comes from debt, preference shares, or common equity. Understanding WACC is essential because it acts as a benchmark rate. It's the minimum return the company must earn on its investment projects to maintain its current value and satisfy all capital providers. Before we move on to discuss the marginal cost of capital, also known as MCC, it's very important to understand a concept called breakpoint. So what exactly is a breakpoint? The breakpoint is the level of new capital investment where the cost of one component of capital changes, typically due to limits on retained earnings or other internal funding sources. It is the point at which the company has used up the cheaper form of financing, such as retained earnings, and now has to raise additional capital from more expensive sources, like issuing new equity. To put it simply, the breakpoint tells us when the company will move to a higher marginal cost of capital. Let's look at the formula used to calculate the breakpoint. Breakpoint equals limit of a source divided by proportion of the source in the capital structure. Let's break that down with an example to see how it works in the context of new capital and marginal cost of capital, or MCC. Let's say a company maintains a standard capital mix consisting of 30% debt, 20% preference shares, and 50% equity. This means for every dollar of capital the company raises, 50 cents comes from equity, and that equity portion can initially be funded through retained earnings. Now, the company has retained earnings available amounting to $100,000. We are told that the company will only issue new common stock after fully utilizing this retained income. So our question is, what is the maximum total capital the company can raise before needing to issue new common stock? To find this, we use the breakpoint formula. Breakpoint equals limit of the capital source divided by proportion of that source in the capital structure. In this case, breakpoint equals $100,000 divided by 0.50. Breakpoint equals $200,000. This means the company can raise up to $200,000 in total capital while still relying completely on retained earnings for the equity portion. After that point, any additional capital raised will require issuing new common stock, which may come with additional flotation costs or increased expectations from shareholders. So to summarize, breakpoint helps us identify how much capital we can raise at the current cost levels. Once we cross the breakpoint, the marginal cost of capital increases because we shift to more expensive sources of financing. Before we wrap up this session, let's take a quick recap of what we have covered in this episode. We started with an introduction to capital structure, understanding how companies finance their operations using a mix of debt, preference shares, and equity. Then, we discussed the importance of capital structure and how choosing the right mix can lower the overall cost of capital and maximize shareholder value. Next, we studied the cost of each component, that is, how to calculate the cost of debt, the cost of preference shares, and the cost of common equity. We then moved on to WACC, the weighted average cost of capital, and learned how to calculate it using the market value proportions and respective component costs. We also understood why retained earnings are not considered separately since they are part of the company's own funds and have no direct cost. After that, we explored the concept of breakpoints, identifying the level of total capital a company can raise before it has to shift from using retained earnings to issuing new common stock. And finally, we touched on the marginal cost of capital, how WACC changes as the company raises more capital in stages. Thank you for watching this episode. As always, I encourage you to practice related questions, read your textbook thoroughly, and most importantly, keep practicing more and more because practice builds clarity and confidence. See you in the next episode. Until then, happy learning and stay consistent.