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CFA Level I Exam · Capital Structure

Weighted Average Cost of Capital for CFA Level I

Updated 7 October 2026 · Fact-checked

WACC is the average rate a firm pays to fund its assets, weighted by each source's share of capital. Find the after-tax cost of debt, the cost of preferred stock and the cost of equity, multiply each by its market-value weight, and add them. Use WACC as the discount rate for average-risk projects.

Understand Capital Structure and Cost of Capital Basics

A firm funds its assets with a mix of debt, preferred stock and common equity. This mix is its capital structure. Each source asks for a return. Lenders want interest. Preferred holders want a fixed dividend. Common shareholders want a return that compensates for the most risk.

The cost of capital is the return each group requires. For the firm, it is the cost of raising that money. Debt is cheapest because lenders are paid first and interest is tax deductible. Equity is most expensive because shareholders are paid last. Preferred stock sits in between.

The weighted average cost of capital (WACC) blends these costs into one number. Each cost is weighted by that source's share of total capital. Use market values for the weights, not book values. Market values show what investors would pay today, and the required returns are also market-based. If a question gives a target capital structure, use the target weights instead.

The cost of debt is the yield to maturity (YTM) on the firm's debt, not the coupon rate. The coupon is a past promise. The YTM is today's required return. Because interest cuts taxes, you use the after-tax cost: rd × (1 − t). Dividends on preferred and common stock are not tax deductible, so no tax adjustment applies to them.

The cost of equity cannot be observed, so you estimate it. The main methods are CAPM, the dividend discount model (DDM, or Gordon growth) and the bond-yield-plus-risk-premium approach. CAPM uses risk (beta). The DDM uses the current price, the next dividend and expected growth. Both are estimates, so they can differ.

Key formulas to remember

WACC
WACC = wd × rd × (1 − t) + wp × rp + we × re
Weights are market-value proportions (or target weights if given) and must sum to 1. Drop the preferred term if the firm has none.
After-tax cost of debt
rd(1 − t), where rd = YTM
Use the current YTM, not the coupon rate. Tax applies only to debt.
Cost of preferred stock
rp = Dp ÷ Pp
For non-callable, non-convertible perpetual preferred. Dp is the annual dividend and Pp is the current price.
Cost of equity: CAPM
re = rf + β × (E(Rm) − rf)
(E(Rm) − rf) is the equity risk premium. If the question gives the premium directly, multiply it by β.
Cost of equity: DDM (Gordon growth)
re = D1 ÷ P0 + g, with D1 = D0 × (1 + g)
Assumes constant dividend growth. Check whether the question gives D0 or D1.
Cost of equity: bond yield plus risk premium
re = rd + risk premium
Here rd is the firm's pre-tax yield on its long-term debt. The premium is a judgemental add-on for equity risk.
Market-value weight
wi = market value of source i ÷ total market value of all capital
Market value of equity = shares outstanding × price. Book values are not used for weights.

How to solve Capital Structure and Cost of Capital Basics questions

Use this order for any WACC or cost-of-capital question. It keeps you from missing a step under time pressure.

  1. 1List the capital sources in the question: debt, preferred stock, common equity. Note the tax rate.
  2. 2Find the weights. Use market values or the stated target structure. Divide each source by the total.
  3. 3Find the cost of debt. Use the YTM, then multiply by (1 − t).
  4. 4Find the cost of preferred stock as dividend ÷ price. Apply no tax adjustment.
  5. 5Find the cost of equity with the method the question gives (CAPM, DDM or bond yield plus premium). For DDM, use D1, not D0.
  6. 6Multiply each cost by its weight and add them. Check that the weights sum to 1.
  7. 7Sanity check: the result should fall between the cheapest and the dearest cost. Then pick the matching option.

Quickest way: Weights first, then a three-line sum

When to use it: Use this when all inputs are given and you have about 90 seconds. It also works to eliminate options quickly.

  1. Write the weights as decimals that sum to 1. Convert amounts to proportions first.
  2. Compute the three after-tax costs mentally or on the calculator.
  3. Compute the WACC with one chain: weight × cost + weight × cost + weight × cost.
  4. Check the answer lies between the lowest and highest cost. A WACC above the cost of equity is wrong.
  5. If two options differ by exactly the tax effect (for example, one uses the pre-tax debt cost), the correct one has the after-tax debt cost.

Common mistakes in Capital Structure and Cost of Capital Basics

  • Using pre-tax cost of debt in WACC

    The question gives the YTM or coupon and you plug it straight in.

    Fix: Always multiply debt cost by (1 − t) before weighting. Apply it to debt only.

  • Using book value weights

    Balance sheet numbers are easy to find and look official.

    Fix: Use market values unless the question gives target weights. If only book debt is given as a proxy for market debt, use it as stated, but equity still uses market capitalisation.

  • Using D0 instead of D1 in the DDM

    The question gives the dividend just paid and you divide it by price.

    Fix: Compute D1 = D0 × (1 + g) first, then re = D1 ÷ P0 + g.

  • Using the coupon rate as the cost of debt

    The coupon is stated clearly and the YTM needs a calculation.

    Fix: Use the YTM. On the BA II Plus, enter N, PV (negative price), PMT, FV, then CPT I/Y. Double the result for semiannual coupons.

  • Taxing the cost of preferred stock

    Preferred looks like debt because the dividend is fixed.

    Fix: Preferred dividends are paid from after-tax profit. Use Dp ÷ Pp with no tax adjustment.

  • Forgetting the risk-free rate in CAPM

    The question gives a market return and a risk premium, and the two are mixed up.

    Fix: If given the market return, subtract rf to get the premium. Then re = rf + β × premium.

Worked examples

Example 1

A company has debt with a market value of $400 million and a YTM of 6%, preferred stock with a market value of $100 million paying a $5.00 annual dividend on a $62.50 price, and common equity with a market value of $500 million. The tax rate is 25%, the risk-free rate is 3%, the equity beta is 1.2 and the equity risk premium is 5%. What is the WACC? A) 6.5% B) 7.1% C) 7.7%

Show the solution
  1. Weights: total capital = 400 + 100 + 500 = $1,000 million. Debt 0.40, preferred 0.10, equity 0.50.
  2. After-tax cost of debt = 6% × (1 − 0.25) = 4.5%.
  3. Cost of preferred = 5.00 ÷ 62.50 = 8.0%.
  4. Cost of equity (CAPM) = 3% + 1.2 × 5% = 9.0%.
  5. WACC = 0.40 × 4.5% + 0.10 × 8.0% + 0.50 × 9.0% = 1.8% + 0.8% + 4.5% = 7.1%.
  6. Check: option C (7.7%) results from using the pre-tax debt cost: 2.4% + 0.8% + 4.5%.

Answer: B) 7.1%

Example 2

A firm's stock trades at €40.00. It just paid a dividend of €2.00 per share, and dividends are expected to grow at 4% a year indefinitely. Using the dividend discount model, what is the cost of equity? A) 5.2% B) 9.0% C) 9.2%

Show the solution
  1. Find the next dividend: D1 = 2.00 × 1.04 = €2.08.
  2. Dividend yield = D1 ÷ P0 = 2.08 ÷ 40.00 = 5.2%.
  3. Add growth: re = 5.2% + 4.0% = 9.2%.
  4. Check the traps: option A is the dividend yield alone. Option B uses D0 ÷ P0 + g = 5.0% + 4.0% = 9.0%.

Answer: C) 9.2%

Exam tips

  • Read the tax rate and note which source it applies to. Most WACC traps are the missing (1 − t) on debt.
  • When the stem gives amounts and prices for each source, build weights from market values. Do not use the book values shown in a balance sheet extract.
  • Check whether the dividend is D0 or D1 before using the DDM. The wording 'just paid' or 'recently paid' means D0.
  • Use the answer range as a check. WACC must sit between the lowest and highest component cost, which often removes one or two of the three options.
  • Be ready to choose between CAPM and DDM conceptually. CAPM needs beta and a risk premium. The DDM needs price, dividend and a stable growth rate.

Practice questions from Capital Structure

Capital Structure and Cost of Capital Basics in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Capital Structure and Cost of Capital Basics: frequently asked questions

What is the difference between book value and market value weights in WACC?

Book value weights use accounting figures from the balance sheet. Market value weights use current prices, such as shares outstanding times share price. Market weights are preferred because the required returns reflect today's market, and book values can be far from what investors would pay.

Is the cost of equity from CAPM the same as from the dividend discount model?

Not usually. CAPM is built from beta and the market risk premium, while the DDM is built from the share price, next dividend and growth. Each is an estimate, so they can differ. Use the method the question names.

Why is the cost of debt taxed but the cost of equity is not?

Interest is tax deductible, so the firm's real cost is lower than the interest paid. Dividends on preferred and common stock are paid out of after-tax profit, so they get no tax shield. Only debt is multiplied by (1 − t).

How do I calculate the YTM on the BA II Plus?

Enter N as the number of periods, PV as the negative of the bond price, PMT as the coupon per period and FV as the face value. Then press CPT, then I/Y. If coupons are semiannual, multiply the I/Y result by 2 for the annual YTM.