Updated for the 2026-2027 CFA® Level I curriculum.
A company raises capital from three main sources: debt, preferred stock, and common equity. Each source has a different cost, and each cost is estimated with a different method. CFA Level I asks you to calculate these three component costs and understand why each method fits its source. This note builds directly on capital structure and feeds straight into the weighted-average cost of capital (WACC).
Quick Answer
The cost of debt is usually estimated using the yield to maturity on a company’s debt, then adjusted for taxes.
After-tax cost of debt:
The cost of preferred stock is the preferred dividend divided by the current market price of the preferred stock.
Cost of preferred stock:
The cost of equity is commonly estimated using the Capital Asset Pricing Model (CAPM).
Cost of equity using CAPM:
These three component costs feed into WACC using their respective market-value weights.
Key Takeaways
Cost of debt, preferred stock, and equity are estimated separately because each security has different cash flows, risk, and tax treatment.
After-tax cost of debt is what belongs in WACC, not the pre-tax yield.
Cost of preferred stock uses a simple perpetuity formula: dividend divided by price.
Cost of equity is typically estimated with CAPM at Level I, using beta, the risk-free rate, and the equity risk premium.
Beta, country risk premiums, and flotation costs adjust the equity or debt estimate but do not change the underlying method.
A common trap is using the coupon rate instead of the yield to maturity when estimating the cost of debt.
All three component costs are inputs to WACC, weighted by their proportion in the capital structure.
What You Need to Know for CFA Level I
Calculate the before-tax and after-tax cost of debt using the yield to maturity approach.
Calculate the cost of preferred stock using the dividend-to-price formula.
Calculate the cost of equity using CAPM, and recognize the required inputs.
Understand why taxes reduce the effective cost of debt but do not affect the cost of preferred stock or equity.
Recognize how beta, country risk premium, and flotation costs adjust a component-cost estimate.
Connect each component cost to its role as a weighted input in the WACC formula.
What Are the Component Costs of Capital?
Every company blends debt, preferred stock, and common equity to fund its operations. Each source demands a different return because each carries different risk and different tax treatment. Debt holders receive fixed interest payments and have first claim on assets, so debt is the cheapest source. Preferred stockholders receive fixed dividends but rank behind debt, so preferred stock costs more than debt. Common shareholders bear the most risk and expect the highest return, making equity the most expensive source.
Because these three sources have different risk profiles and cash flow structures, you cannot use one formula for all of them. CFA Level I tests three distinct estimation methods, one for each component.
How to Estimate the Cost of Debt
The most common approach at Level I is the yield to maturity (YTM) method. You find the market yield on the company's existing debt, which reflects what investors currently demand to hold that debt, given its credit risk and maturity.
Because interest expense is tax-deductible, the effective cost of debt to the company is lower than the stated yield. The formula adjusts for this:
After-tax cost of debt
Where:
= before-tax cost of debt (the YTM on existing debt)
= the company's marginal tax rate
If a company cannot observe a market yield (for example, if its debt does not trade), analysts sometimes use a bond-rating-based approach, estimating a yield based on comparable bonds with the same credit rating and maturity. The mechanics of adjusting for taxes stay the same once you have an estimated .
How to Estimate the Cost of Preferred Stock
Preferred stock typically pays a fixed dividend with no maturity date, so it behaves like a perpetuity. The cost of preferred stock is:
Where:
= the annual preferred dividend per share
= the current market price of the preferred share
This formula applies to noncallable, nonconvertible preferred stock, which is the standard case tested at Level I. Unlike debt, preferred dividends are not tax-deductible, so there is no tax adjustment here.
How to Estimate the Cost of Equity
Common equity has no fixed payment and no maturity, which makes it harder to price than debt or preferred stock. CFA Level I focuses on the Capital Asset Pricing Model (CAPM) as the primary method:
Where:
= the risk-free rate
= the stock's beta, measuring its sensitivity to market returns
= the equity risk premium
CAPM says the required return on equity equals the risk-free rate plus a premium for systematic risk, scaled by beta. A beta above 1.0 means the stock is more volatile than the market and requires a higher return. A beta below 1.0 means the opposite.
How Beta, Country Risk, Taxes, and Flotation Costs Affect the Estimate
A few adjustments refine these component-cost estimates without changing the core method.
Beta estimation
Analysts sometimes cannot find a reliable beta for a company, particularly a private firm or one with limited trading history. In that case, they use a comparable public company's beta, unlever it to remove the comparable's capital structure effect, then relever it using the subject company's own capital structure. This adjusted beta feeds into CAPM.
Country risk
For companies operating in markets with higher sovereign risk, analysts may add a country risk premium to the equity risk premium in the CAPM formula. This raises the estimated cost of equity to reflect the additional risk of operating in that market.
Taxes
Taxes only adjust the cost of debt. Interest is tax-deductible, so the after-tax cost of debt is lower than the pre-tax yield. Preferred dividends and common dividends are paid from after-tax income, so no tax adjustment applies to preferred stock or equity.
Flotation costs
These are the costs of issuing new securities, such as underwriting fees. At Level I, flotation costs are treated as a small adjustment to the initial investment analysis rather than a permanent increase to the cost of capital. They are not a separate cost-of-capital method and should not be treated as a standalone topic.
How Component Costs Feed Into WACC
Once you have the after-tax cost of debt, the cost of preferred stock, and the cost of equity, each cost is weighted by its proportion in the company's target capital structure. This weighted sum is the weighted-average cost of capital (WACC), the discount rate used to evaluate a company's investment decisions.
This note focuses on estimating each component cost correctly. For the full weighting formula and worked WACC calculation, see Weighted-Average Cost of Capital: Calculation and Interpretation.
Common Exam Traps
Using the pre-tax cost of debt in WACC. WACC requires the after-tax cost of debt. Forgetting the adjustment overstates the true cost of debt and produces an incorrect WACC.
Confusing dividend yield with the cost of common equity. Dividend yield alone ignores expected growth and risk. CAPM, not a simple yield calculation, is the primary Level I method for common equity.
Using an unadjusted beta from an unrelated company. If a comparable company's capital structure differs significantly from the subject company, its raw beta will not reflect the subject company's risk. The beta must be unlevered and relevered before use in CAPM.
Treating flotation costs as a separate cost-of-capital component. Flotation costs adjust the initial cash flow of a project, not the ongoing cost of capital. Do not add a flotation-cost term directly into , , or .
Applying a tax adjustment to preferred stock or equity. Only interest on debt is tax-deductible. Applying to preferred dividends or equity returns is a common and costly calculation error.
Practice Question
A company's preferred stock pays an annual dividend of $4.50 per share and currently trades at $60 per share. The company's marginal tax rate is 25%.
What is the cost of preferred stock?
5.6%
7.5%
10.0%
Correct Answer: B. 7.5%
The cost of preferred stock equals the preferred dividend divided by the current market price of the preferred stock.
Preferred dividends are not tax-deductible, so no after-tax adjustment applies to the cost of preferred stock.
Option A. This choice incorrectly applies the 25% tax adjustment, as if preferred stock received the same tax treatment as debt.
Option C. This choice appears to divide an incorrect numerator or misapply the formula components rather than using directly.
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FAQs About Cost of Debt, Preferred Stock, and Equity
Why does the cost of debt use an after-tax figure but the cost of equity does not?
Interest payments on debt are tax-deductible, which lowers the company's effective borrowing cost. Dividends paid to preferred and common shareholders come from after-tax income, so there is no equivalent tax adjustment for those components.
Can dividend discount model be used instead of CAPM for cost of equity?
Level I focuses primarily on CAPM for estimating the cost of equity. The dividend discount model approach appears in other contexts within the curriculum, but CAPM is the method most directly tied to component-cost estimation.
Why does preferred stock cost more than debt but less than equity?
Preferred stock ranks behind debt in a company's capital structure but ahead of common equity. This middle position means preferred shareholders take on more risk than debt holders but less than common shareholders, which places its required return between the two.