Skip to content

CFA Level II · CFA Level II Exam

Cost of Capital: Advanced Topics for CFA Level II

Cost of capital is the return investors require for funding a firm. WACC blends the after-tax cost of debt, preferred stock and equity using target weights. To solve questions, find the right inputs in the vignette, estimate each component with the stated model, then weight and apply them to a project's cash flows.

What this chapter covers

Cost of capital concepts appear in both Corporate Finance and Equity Valuation. You build on the WACC you met at Level I. You estimate each component of capital carefully: debt from yields and ratings, preferred stock from a perpetuity, and common equity from CAPM, multifactor and build-up models. You also adjust beta for leverage and for country risk, and treat flotation costs correctly in capital budgeting.

Note where each idea sits in the curriculum. Build-up and multifactor cost of equity models belong mainly to Equity Valuation. Corporate Finance at Level II focuses on capital structure, dividends and M&A. This page gathers the cost of capital tools from both areas so you can study them together.

The vignette rarely hands you a finished input. You may get a bond's yield to maturity, a coupon rate, a debt rating matrix, a comparable firm's beta at a different capital structure, or a sovereign yield spread. Your job is to pick the right figure, for example the current market yield and not the coupon, and then apply the model.

The chapter links to several other topics. Corporate Finance uses the WACC to discount project cash flows in capital budgeting. Equity Valuation uses the required return on equity as the discount rate in dividend discount and residual income models. Portfolio Management uses CAPM and multifactor ideas. Fixed Income supplies yield concepts for the cost of debt. Getting these ideas right helps you across many item sets.

Cost of capital is a calculation-heavy topic where each step is mechanical, so well-prepared candidates can collect marks reliably. Its inputs (required return on equity, WACC, beta) appear in Corporate Finance, equity valuation, portfolio construction and capital budgeting questions. The 5-10% weight listed for Corporate Finance applies to that topic as a whole, not to this subject alone. Because Level II questions come from a vignette, one weak link, such as forgetting to relever beta or to deduct tax from debt cost, can cost you several questions in the same set. A few hours of focused practice here pays back in other topics too.

Cost of Capital: Advanced Topics: topics in the order to study them

  1. 1Cost of Capital Fundamentals and WACC ReviewStart here to refresh the WACC formula, target weights and the tax shield, since every later topic feeds one of its inputs.
  2. 2Cost of Debt EstimationDebt is the simplest component, and it teaches you to use current market yields, not coupons, and to apply tax after estimating the pre-tax cost.
  3. 3Cost of Preferred Stock and Common Equity (CAPM)Preferred stock is a quick perpetuity, and CAPM gives you the core equity model that the rest of the chapter refines.
  4. 4Beta Estimation and Country Risk PremiumOnce CAPM is clear, you learn how its beta input is estimated, unlevered and relevered, and how country risk is added for emerging markets.
  5. 5Expected Return Models: Multifactor and Build-Up MethodsThese are alternatives to CAPM, so they make sense only after you know what CAPM does and where it falls short, for example for private firms.
  6. 6Flotation Costs and Capital Budgeting AdjustmentsFinish with this applied topic, which combines the earlier components and shows how issuance costs should enter the project's cash flows.

How to prepare Cost of Capital: Advanced Topics

Treat this chapter as a set of small formulas that you chain together. Practise by reading vignettes and picking the right inputs.

  1. Write the WACC formula from memory: WACC = wd × rd × (1 − t) + wp × rp + we × re. Confirm you use market-value target weights.
  2. Practise cost of debt from a yield to maturity, a rating-based yield and a matrix-pricing estimate. Always convert to after-tax last.
  3. Learn CAPM, then the beta process in order: unlever the comparable's beta, average if needed, relever at the target capital structure. Do this on paper until it is automatic.
  4. Add the country risk premium to a worked example. Use CRP = sovereign yield spread × (annualized equity index volatility ÷ annualized sovereign bond volatility). The CRP can be added inside the beta bracket, with the market premium: re = Rf + β × [E(Rmkt) − Rf + CRP]. Some treatments add it outside the beta term instead: re = Rf + β × [E(Rmkt) − Rf] + CRP. Follow the method the vignette states, and read it to see which inputs it gives you.
  5. Compare CAPM, multifactor and build-up models side by side, listing the inputs each one needs and when each is suitable.
  6. Work flotation cost questions. Adjust the project's initial outlay, not the discount rate, and check what the vignette tells you about the issue.
  7. Finish with timed item sets. After each, check which input you misread, and keep a short error log.

Common mistakes in Cost of Capital: Advanced Topics

  • Using the bond's coupon rate as the cost of debt.

    Fix: Use the current yield to maturity or a yield matched to the firm's rating and maturity, then apply the tax adjustment.

  • Forgetting to deduct the tax shield, or applying it to equity or preferred stock.

    Fix: Only interest is tax deductible. Write (1 − t) beside rd and nowhere else.

  • Using the comparable company's beta directly without adjusting for capital structure.

    Fix: Whenever leverage differs, unlever the comparable's beta, then relever at the target firm's structure.

  • Using book-value weights or current weights when a target structure is given.

    Fix: Use the target weights if stated, otherwise market values of debt and equity.

  • Raising the discount rate to account for flotation costs.

    Fix: Include flotation cost as part of the initial investment outlay so the NPV reflects it directly.

  • Using the raw sovereign spread as the country risk premium without scaling, or placing the CRP in the formula differently from the method the vignette states.

    Fix: Compute CRP = sovereign spread × (equity index volatility ÷ sovereign bond volatility), then add it as the vignette directs, for example re = Rf + β × [E(Rmkt) − Rf + CRP] when it sits inside the bracket.

Last-day revision: Cost of Capital: Advanced Topics

  • WACC = wd × rd × (1 − t) + wp × rp + we × re, using target market-value weights.
  • Cost of debt is the current market yield for new borrowing, not the historical coupon rate.
  • Only debt gets the tax shield: multiply by (1 − t).
  • Cost of preferred stock = dividend ÷ price, since it is a perpetuity.
  • CAPM: re = Rf + β × (equity risk premium).
  • Unlever the comparable's beta, then relever at the target firm's debt-to-equity ratio.
  • Higher leverage raises equity beta.
  • CRP = sovereign yield spread × (annualized equity index volatility ÷ annualized sovereign bond volatility). It can go inside the beta bracket: re = Rf + β × [E(Rmkt) − Rf + CRP]. Some treatments add it outside: re = Rf + β × [E(Rmkt) − Rf] + CRP. Follow the method the vignette states.
  • Multifactor models add factor risk premia times factor sensitivities to the risk-free rate.
  • Build-up: risk-free rate + equity risk premium + size premium + specific risk premium, used mainly for private firms.
  • Flotation costs are best handled as an adjustment to the project's cash outflow, not by raising the cost of capital.
  • The marginal cost of capital typically rises as more capital is raised, with breakpoints where a component's cost increases.

Cost of Capital: Advanced Topics in other exams

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

Cost of Capital: Advanced Topics: frequently asked questions

Is cost of capital a high-weight topic in CFA Level II?

Cost of capital concepts appear in Corporate Finance and Equity Valuation. The 5-10% weight belongs to Corporate Finance as a whole, not to this subject alone. Its inputs also feed Equity and Portfolio topics, so the benefit goes beyond that weight.

Do I need to memorise the unlevering and relevering formulas?

Yes, you should be able to apply them without hesitation, because beta questions usually depend on them. Practise them with different tax and debt-to-equity inputs until the steps are routine.

Which cost of equity model should I use in the exam?

Use the model the vignette points to or provides inputs for. CAPM works for listed firms with a beta, multifactor models suit cases with several factor premia, and build-up methods suit private firms without a usable beta.

Should flotation costs change the WACC?

The recommended treatment is to adjust the project's cash flows, usually the initial outlay, rather than the WACC. Adjusting the rate misstates the cost because flotation is a one-time expense.