CFA Level 1 Cost of Capital: WACC, Capital Structure & Modigliani-Miller
The Weighted-Average Cost of Capital (WACC)
A company’s WACC represents the blended required return across all sources of financing. It’s the discount rate used in NPV analysis and the hurdle rate for IRR — so getting it right is critical for capital allocation decisions.
Where w_d = weight of debt, r_d = pre-tax cost of debt, t = marginal tax rate, w_e = weight of equity, r_e = cost of equity. If the company also has preferred stock: add (w_p × r_p) to the formula.
Component Breakdown
| Component | How to Estimate | Key Considerations |
|---|---|---|
| Cost of Debt (r_d) | YTM on existing bonds, or interest rate on new borrowing | Use after-tax cost: r_d × (1 − t). Tax deductibility of interest reduces the effective cost. Use marginal (not average) tax rate. |
| Cost of Equity (r_e) | CAPM: r_e = r_f + β × (Market Risk Premium) | No observable market rate — must be estimated. Always higher than cost of debt (equity bears more risk, no tax deductibility). |
| Cost of Preferred Stock (r_p) | r_p = Preferred Dividend / Market Price of Preferred | Preferred dividends are typically not tax-deductible — no tax adjustment needed. |
| Weights (w_d, w_e) | Market value proportions, or management’s target weights | Market value weights are preferred because they reflect current investor opportunity costs. Book value weights may be used when market values aren’t available. |
WACC Worked Example
A company has 40% debt (cost of debt = 4%) and 60% equity (cost of equity = 10%). Marginal tax rate = 23%.
The after-tax cost of debt (0.04 × 0.77 = 3.08%) is substantially lower than the cost of equity (10%). This spread is what makes debt financing attractive — up to a point.
Factors Affecting Capital Structure
A company’s choice between debt and equity financing depends on both internal and external factors.
Internal Factors
| Factor | Effect on Capital Structure |
|---|---|
| Business model | Capital-intensive firms (utilities, real estate) typically use more debt. Asset-light firms (tech, services) rely more on equity. |
| Revenue stability | Stable, predictable cash flows support higher debt capacity. Volatile revenue increases financial distress risk. |
| Operating leverage | High operating leverage (high fixed costs) means earnings are already volatile — adding financial leverage amplifies this risk. |
| Life cycle stage | Young/growth companies use more equity (uncertain cash flows). Mature companies can support more debt (stable operations). |
| Tangibility of assets | Tangible assets serve as collateral, reducing cost of debt. Firms with mostly intangible assets face higher borrowing costs. |
External Factors
| Factor | Effect |
|---|---|
| Interest rate environment | Low rates favor debt issuance. Rising rates increase cost of debt and may shift preference toward equity. |
| Tax regime | Higher corporate tax rates increase the value of the interest tax shield, favoring more debt. |
| Industry norms | Companies in the same industry tend to have similar capital structures. Deviating significantly may signal risk or opportunity. |
| Market conditions | Strong equity markets favor equity issuance. Tight credit conditions constrain debt financing. |
Modigliani-Miller Propositions
The Modigliani-Miller (MM) framework is the theoretical foundation for understanding how capital structure affects firm value and WACC. The exam tests both the “without taxes” and “with taxes” versions.
MM Assumptions
MM’s original analysis assumes no taxes, no transaction costs, no bankruptcy costs, symmetric information between managers and investors, and that individuals can borrow at the same rate as corporations. These assumptions are unrealistic — that’s the point. They establish a baseline, and relaxing each assumption reveals how capital structure matters in the real world.
MM Without Taxes
| Proposition | Statement | Implication |
|---|---|---|
| Proposition I | The value of a levered firm equals the value of an unlevered firm: V_L = V_U | Capital structure is irrelevant to firm value. You can’t create value by simply changing the debt/equity mix. |
| Proposition II | r_e = r_0 + (r_0 − r_d) × (D/E) | The cost of equity rises linearly with leverage. The benefit of cheaper debt is exactly offset by the increased cost of equity, so WACC stays constant. |
Where r_e = cost of equity, r_0 = cost of capital for an all-equity firm (unlevered cost), r_d = cost of debt, D/E = debt-to-equity ratio.
MM With Taxes
| Proposition | Statement | Implication |
|---|---|---|
| Proposition I with Taxes | V_L = V_U + tD | The levered firm is worth more than the unlevered firm by the present value of the tax shield (t × D). More debt = more value. |
| Proposition II with Taxes | r_e = r_0 + (r_0 − r_d) × (1 − t) × (D/E) | Cost of equity still rises with leverage, but by less than in the no-tax case. The tax shield makes debt genuinely cheaper, so WACC decreases as leverage increases. |
Financial Distress and Optimal Capital Structure
Costs of Financial Distress
Financial distress occurs when a company struggles to meet its debt obligations. The costs come in two forms:
| Type | Description | Examples |
|---|---|---|
| Direct Costs | Cash expenses directly associated with bankruptcy proceedings | Legal fees, administrative costs, court expenses, advisor fees |
| Indirect Costs | Lost business value from distress — often much larger than direct costs | Lost customers, supplier reluctance, employee departures, forgone investment, reputational damage |
Distress costs are lower for firms with tangible, marketable assets (airlines, real estate) and higher for firms dependent on intangibles (tech, pharma, services).
The Static Trade-Off Theory
The static trade-off theory balances the tax benefit of debt against the costs of financial distress:
At low debt levels, the tax shield dominates — adding debt increases firm value and decreases WACC. Beyond a critical point (D*), the probability-weighted costs of financial distress overtake the tax benefit. The debt level that maximizes firm value is the optimal capital structure.
| Debt Level | Tax Shield Effect | Distress Cost Effect | Net Impact on Value |
|---|---|---|---|
| Low debt (below D*) | Strong — tax savings are significant | Minimal — default probability is low | Value increases — add more debt |
| At D* (optimal) | Marginal benefit equals marginal cost | Marginal cost equals marginal benefit | Firm value maximized |
| High debt (above D*) | Still present but diminishing | Dominant — distress probability is high | Value decreases — too much debt |
Target Capital Structure
In practice, managers can’t pinpoint D* exactly. Instead, they set a target capital structure — typically expressed as a range (e.g., 30–50% debt) rather than a precise number.
When analysts need to estimate a company’s target capital structure and management hasn’t disclosed it, they can use one of three approaches: assume the current market-value capital structure is the target, examine capital structure trends and management commentary for signals, or use the average capital structure of comparable companies.
Target capital structures are often stated in book value terms or indirectly through financial leverage constraints like a maximum debt-to-equity ratio, a maximum net debt/EBITDA ratio, or a minimum credit rating.
Pecking Order Theory
The pecking order theory provides an alternative explanation for capital structure decisions — one based on information asymmetry rather than tax optimization.
Managers know more about the company than outside investors. When a company issues new equity, investors assume it’s because management believes the stock is overvalued — so the stock price drops. To avoid this signaling problem, managers prefer financing sources that carry less information asymmetry.
The pecking order of financing preferences:
- Internal funds (retained earnings) — no external signaling, no issuance costs
- Debt — less negative signal than equity, contractual obligations are clearer
- Equity — last resort because it sends the most negative signal about valuation
Agency Costs
Agency costs arise from conflicts of interest between stakeholders:
| Conflict | Description | Capital Structure Implication |
|---|---|---|
| Managers vs. Shareholders | Managers may pursue empire-building, excessive perks, or risk-averse strategies that don’t maximize shareholder value | Debt disciplines management by requiring fixed payments — the “discipline of debt” hypothesis. More debt = less free cash for managers to waste. |
| Shareholders vs. Debtholders | Near bankruptcy, shareholders may prefer risky projects (upside goes to equity, downside borne by debt). Shareholders may also resist positive-NPV projects if benefits accrue mostly to debtholders. | These agency costs of debt increase the cost of borrowing and reduce optimal leverage. Covenant protections partially mitigate this. |
Cross-Curriculum Connections
| Concept | Where It Connects |
|---|---|
| WACC as discount rate | Corporate Issuers — NPV/IRR capital allocation; Equity Investments — DCF valuation |
| Cost of equity (CAPM) | Portfolio Management — beta, security market line, required return |
| After-tax cost of debt | Income Taxes — tax deductibility of interest, effective tax rate |
| Financial leverage | Financial Analysis Techniques — DuPont leverage multiplier, solvency ratios |
| Cost of debt / YTM | Fixed Income — bond pricing, yield to maturity, credit spreads |
| Financial distress | Fixed Income — credit analysis, default risk, credit ratings |
Study Strategy
- Nail the WACC formula first. Practice computing WACC with different scenarios — varying weights, tax rates, and the addition of preferred stock. This is the most straightforward points available.
- Learn MM propositions in pairs. Each proposition has a “no taxes” and “with taxes” version. Know both formulas and — more importantly — know what changes between them. The exam loves asking “what happens to cost of equity/WACC when debt increases?”
- Understand the static trade-off diagram. Visualize the inverted-U relationship between debt and firm value. Know where D* sits and why the curve turns down.
- Contrast the theories. Trade-off theory predicts a target capital structure. Pecking order theory predicts a financing hierarchy. The exam may give you a scenario and ask which theory explains the company’s behavior.
- Don’t neglect agency costs. The shareholder-debtholder conflict (risk shifting near bankruptcy) is a favorite exam question.
For all formulas in one place, see the CFA Level 1 Formula Sheet. For practice problems across all topics, visit Practice Questions.
Key Takeaways
- WACC = (w_d × r_d × (1 − t)) + (w_e × r_e). The tax shield on interest makes debt cheaper on an after-tax basis. Use market value weights unless the question specifies otherwise.
- Cost of debt is observed from YTM on existing bonds; cost of equity is estimated (typically via CAPM). Cost of equity is always higher than cost of debt.
- MM Proposition I without taxes: capital structure is irrelevant (V_L = V_U). MM Proposition II without taxes: cost of equity rises linearly with leverage, exactly offsetting cheaper debt — WACC stays constant.
- MM with taxes: V_L = V_U + tD. The tax shield creates real value. WACC decreases as leverage increases. Cost of equity still rises but by less (the (1 − t) dampening factor).
- The static trade-off theory balances tax benefits against financial distress costs: V_L = V_U + tD − PV(distress costs). The optimal capital structure (D*) maximizes firm value.
- The pecking order theory says firms prefer internal funds first, then debt, then equity last — driven by information asymmetry, not tax optimization.
- Agency costs of debt (risk shifting, underinvestment near bankruptcy) increase with leverage and partially offset the tax benefit of debt.
- In practice, companies set target capital structure ranges rather than exact debt levels, and actual capital structures may deviate due to market conditions and transaction costs.
Frequently Asked Questions
Why is the after-tax cost of debt used in WACC but not the after-tax cost of equity?
Because interest expense is tax-deductible in most jurisdictions, which reduces the effective cost to the company. Dividend payments to equity holders are not tax-deductible — they come from after-tax income. So the tax adjustment only applies to debt. This asymmetric tax treatment is also what creates the tax shield that drives the MM propositions with taxes.
How does MM Proposition II change with taxes vs. without?
Without taxes, cost of equity rises at the full rate of the debt-equity spread: r_e = r_0 + (r_0 − r_d)(D/E). With taxes, a dampening factor of (1 − t) is introduced: r_e = r_0 + (r_0 − r_d)(1 − t)(D/E). The cost of equity still increases with leverage, but less steeply. This means the benefit of cheaper after-tax debt is no longer fully offset by rising equity costs, so WACC actually falls as the firm takes on more debt.
What determines whether adding leverage increases or decreases ROE?
If the company’s return on assets exceeds its after-tax cost of debt, leverage amplifies returns to equity holders — ROE increases. If ROA is below the after-tax cost of debt, leverage works in reverse and decreases ROE. This connects directly to the DuPont framework covered in Financial Analysis Techniques, where the leverage multiplier boosts ROE but the interest burden component partially offsets it.
Why doesn’t the optimal capital structure work out to 100% debt?
Because the MM model with taxes ignores financial distress costs. Once you incorporate the probability-weighted costs of bankruptcy (legal fees, lost customers, broken supplier relationships, management distraction), those costs eventually outweigh the incremental tax shield from additional debt. The static trade-off theory captures this: firm value is maximized at the point where the marginal tax benefit equals the marginal distress cost.
How do I distinguish between trade-off theory and pecking order theory on the exam?
Trade-off theory predicts that firms have a target capital structure and will issue debt or equity to move toward it. Pecking order theory predicts that firms don’t have a target — they simply use the cheapest available financing source, preferring retained earnings over debt, and debt over equity. If a question describes a profitable company with low leverage that avoids issuing equity, that’s pecking order behavior. If a company actively manages its debt ratio toward a stated target, that’s trade-off theory.
Should I use market value or book value weights for WACC on the CFA exam?
Default to market value weights — they reflect current economic reality and investors’ opportunity costs. Use book value weights only if the question explicitly states to do so, or if management’s target capital structure is expressed in book value terms. If neither market values nor targets are given, you can estimate market value of equity from share price times shares outstanding, and approximate market value of debt from its book value if the company’s credit quality hasn’t changed significantly.