Numerous other studies show that high-yielding dividend and distribution growth stocks are among the best kinds of long-term investments you can make. That's why master limited partnerships, or MLPs, with their penchant for high and growing yields, are an increasingly popular investment class. 

To invest smartly in these kinds of stocks, there are two important concepts that all MLP investors need to understand. This should help you better monitor your investments to make sure that the partnerships you entrust with their hard-earned money are being run well and likely to continue growing. 

Cost of capital: what it is, why it matters to you, and how to calculate it

The cost of capital is the weighted average of these two funding sources and can be thought of as the "hurdle rate" management uses to decide whether a new project or acquisition makes sense. The lower the cost of capital, the better an MLP's profitability will be and the larger its potential pool of growth projects is.  

To calculate cost of capital, you need two things: the proportion of funding that comes from both sources, and the cost of both debt and equity funding. To determine the first component, add the market cap of the MLP to its total debt and then find the proportion from each source of that total figure.

The cost of debt and equity can be found in several places, such as MLPdata.com, with debt funding being from the partnership's most recent debt offering, which can also be found at Morningstar.com or in a partnership 10Q. Once you have both sets of data, just multiply the proportion of each kind of funding (as a decimal) by the respective cost of funding to determine the weighted average cost of capital. 

Now that you have a basic understanding of what the cost of capital is, why it matters, and how to find it, let's look deeper into the reason some MLPs have such higher costs of equity and thus higher total WACCs.

Midstream MLPs have long-term, fixed-term contracts that help insulate them from swings in energy prices, which means cash flows are less exposed to energy price volatility. The upstream MLPs, while they do use hedges to increase cash flow predictability, have more volatile cash flows simply because hedges are typically only for two- to three-year terms, compared with 10- to 20-year terms that most midstream contracts enjoy.

Cost of equity

Cost of equity can be thought of as the minimum rate of return the market demands for buying units in an MLP. One way of calculating cost of equity is based on the capital asset pricing model, or CAPM. This model estimates what minimum return investors need to compensate them for the risk of investing in an asset that's riskier than a "risk-free" return such as those provided by 10-year Treasuries. The formula is:

Cost of equity = risk free return + (market's expected return-risk free return) * beta 

Beta is simply a measure of the volatility of a security compared with the market's volatility. For example, right now the Treasury rate is 2.31% and between 1871 and 2013, the S&P 500 has grown at an annual compound rate of 9.1%.

So for an MLP with a beta of 0.5 (50% less volatile than market), the cost of equity, or minimum risk-adjusted rate of return investors expect, would be 2.31 + (9.1-2.31) * 0.5, or 5.71%.

While the CAPM model is one way of determining the cost of equity, what's more important to know is the basic principles of the concept. Each investor will have his or her own cost of equity based on individual preferences related to one's risk tolerances, investing time horizon, and goals (income versus growth, for example).

Three ways MLPs can lower their cost of capital 

Given how important a low cost of capital is for MLP growth, partnerships can do several things to lower their WACC. For example, MLPs usually have general partners that manage the partnership and collect incentive distribution rights, or IDRs. These grant them a higher proportion of marginal cash flow as the distribution climbs above pre-determined levels, usually up to 50%. The cost of equity then rises because investors--who are limited partners--know that the MLP must earn a return on its investments great enough to pay both them and the general partner. So one way to lower the cost of capital is to buy out or merge with its general partner, something that five midstream MLPs have done:

These MLPs, now being free of IDRs, reduce their costs of capital (via a lower cost of equity) and can devote that extra cash flow to either growing their distributions more quickly or investing in growth projects. MLPs without a general partner often have higher distribution coverage rates (meaning safer distributions), faster distribution growth rates, and usually command substantial market premiums that cause them to trade for slightly lower yields:

MLP Without GPsYieldDistribution Coverage RatioPrice/Distributable Cash Flow
Enterprise Products Partners 3.80% 1.56 17.9
Magellan Midstream Partners 2.90% 1.6 21.3
Genesis Energy 4.80% 1.14 20.23
MarkWest Energy Partners 4.80% 1.12 21.53
Buckeye Partners 5.50% 0.94 21.22
Average of these MLPs 4.36% 1.27 20.44
MLPs With GPs      
Energy Transfer Partners  5.80% 1.22 10.25
Williams Partners  6.90% 0.91 12.06
Enbridge Energy Partners  5.70% 0.85 17.68
Spectra Energy Partners  4.10% 1.38 10.16
Plains All American Pipeline 4.90% 1.16 12.77
Average of these MLPs 5.48% 1.1 12.58

Sources: Yahoo! Finance, MLPdata.com, author calculations.

Another way to lower the cost of capital is for a general partner to buy out its MLPs, as Kinder Morgan (NYSE:KMI) recently did with the three of MLPs under its management. This merger will help lower Kinder's cost of capital and help secure the dividend for years to come. Of note is that as of Nov. 26, when the merger closes, Kinder Morgan will no longer be an MLP but a regular corporation.

Finally, as the Kinder Morgan merger illustrates, mergers can also help lower the cost of capital for reasons other than elimination of IDRs. With greater size usually comes greater economies of scale and sometimes higher credit ratings, as is the case with the Kinder Morgan merger. Each of these factors can help make MLP debt more appealing, lower borrowing costs and, with them, the overall cost of capital.

Bottom line: low cost of capital is key to MLP (and distribution) growth

MLPs can potentially make excellent long-term income investments that can also deliver market-crushing total returns. However, investors would do well to understand important concepts like cost of capital and cost of equity that help determine the health and growth of this industry, and how to track them. To learn more about MLPs you can get access to a wonderful free report from The Motley Fool by clicking here.

Adam Galas has no position in any stocks mentioned. The Motley Fool recommends BreitBurn Energy Partners, Enbridge Energy Partners, Enterprise Products Partners, Kinder Morgan, and Magellan Midstream Partners and owns shares of Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.