Financial Management · Capital structure theories and practical considerations

Cost of Capital and WACC for ACCA FM

Updated 11 October 2026 · Fact-checked

WACC is the average cost of a company's long-term finance, weighted by the market value of each source. Find the cost of equity, the after-tax cost of debt and any other finance, weight each by its market value, and add the results. Use it to discount average-risk projects.

Understand Cost of Capital and WACC Recap

Every source of finance has a cost. Investors who put money in expect a return. The company must earn at least that return, or it destroys value.

Cost of equity is the return shareholders require. It is higher than the cost of debt because shareholders carry more risk. They are paid last, and their dividends are not guaranteed. You estimate it with the dividend valuation model or with CAPM.

Cost of debt is the return lenders require, adjusted for tax. Interest is normally tax deductible, so the real cost to the company is lower. For irredeemable debt you use a simple formula. For redeemable debt you find the yield to maturity (the IRR of the cash flows).

WACC combines these costs into one rate. Each source is weighted by its share of total finance. Use market values, not book values, because market values show what investors would pay today. Equity is usually measured by the number of shares × the share price. Debt is measured by its market price.

WACC is the right discount rate for a project only if the project has the same business risk as the company and does not change its capital structure. If either changes, you need a different rate. WACC also underpins capital structure theory: the question is whether changing the mix of debt and equity can lower WACC and raise company value.

Key rules to remember

Cost of equity (dividend valuation model with growth): Ke = [D0 × (1 + g) ÷ P0] + g; D0 is the dividend just paid. P0 is the ex-dividend share price. g is the constant annual dividend growth rate.
Cost of equity (CAPM): Ke = Rf + β × (Rm − Rf); Rf is the risk-free rate. Rm − Rf is the equity risk premium. β measures systematic risk.
Cost of irredeemable debt (after tax): Kd = i × (1 − T) ÷ P0; i is annual interest per ₹100 nominal. P0 is the ex-interest market price per ₹100 nominal. T is the tax rate.
Cost of redeemable debt: Kd = IRR of: − market price now, + interest × (1 − T) each year, + redemption value at the end; Find it by interpolation between two discount rates. Use the post-tax interest cash flows.
Cost of preference shares: Kp = Preference dividend ÷ Market price; No tax adjustment, because preference dividends are not tax deductible.
Weighted average cost of capital: WACC = [Ve × Ke + Vd × Kd + Vp × Kp] ÷ (Ve + Vd + Vp); V is the total market value of each source. Use the after-tax Kd.

How to solve Cost of Capital and WACC Recap questions

Use this order for any WACC question. It keeps your working clear and earns method marks even if one input is wrong.

1List every source of long-term finance in the question: equity, preference shares, loan notes, bank loans. Ignore short-term finance unless told otherwise.
2Find the market value of each source. For equity, use shares in issue × share price. For debt, use nominal value × quoted price ÷ 100.
3Calculate the cost of equity using the method the question gives: dividend growth model or CAPM.
4Calculate the after-tax cost of each debt source. Irredeemable: use the formula. Redeemable: find the IRR using post-tax interest and the redemption value.
5Calculate the cost of preference shares, if any, with no tax adjustment.
6Multiply each cost by its market value and add the results.
7Divide by total market value to get WACC. Show the working in a small layout.
8State whether WACC suits the purpose, such as discounting a project, and note any limits, such as different risk.

Quickest way: Quick WACC layout

When to use it: Use this in Section A and Section B objective questions, where you have about two to three minutes per question and only the final number matters.

Write three columns: market value, cost, value × cost.
Fill in equity first, then debt. Convert debt cost to after-tax before you enter it.
Add the third column and divide by the total of the first column.
Check the answer lies between the lowest and highest cost. If not, you have made an error.
Check that the debt cost is below the equity cost. If not, you probably forgot tax or mixed up the inputs.

Common mistakes in Cost of Capital and WACC Recap

Using book values for weights.
Statement of financial position figures are easy to find and students use them by habit.
Fix: Use market values whenever they are given. Use book values only if the question gives no market values.
Forgetting to adjust the cost of debt for tax.
Students focus on the yield and treat it as the final cost.
Fix: Multiply interest by (1 − T) before finding the cost. Do not tax-adjust preference share dividends.
Using D0 instead of D0 × (1 + g) in the dividend model.
The formula is memorised without remembering that the numerator is next year's dividend.
Fix: Check which dividend the question gives. If it is the dividend just paid, multiply by (1 + g).
Using the wrong share price for equity value.
Students ignore whether the price is cum-div or ex-div.
Fix: Use the ex-dividend price. If the price is cum-div, subtract the dividend that is about to be paid.
Using the nominal interest rate as the market cost of redeemable debt.
The coupon looks like a cost, but the market price and redemption value also matter.
Fix: Calculate the yield to maturity as an IRR using the market price, post-tax interest and redemption proceeds.
Using WACC for every project.
WACC is the default rate in many questions, so students stop checking the conditions.
Fix: State that WACC is only suitable when project risk and financing mix match the company's existing ones.

Worked examples

Example 1

Alpha Co has 4 million equity shares in issue at a market price of ₹3.00 each. It also has ₹3 million nominal of 8% irredeemable loan notes trading at ₹80 per ₹100 nominal. The latest dividend was ₹0.18 per share and dividends grow at 5% a year. The tax rate is 25%. Calculate the WACC.

Show the solution

Equity market value = 4,000,000 × ₹3.00 = ₹12,000,000.
Debt market value = ₹3,000,000 × 80 ÷ 100 = ₹2,400,000.
Ke = [0.18 × 1.05 ÷ 3.00] + 0.05 = 0.063 + 0.05 = 0.113, or 11.3%.
Kd = 8 × (1 − 0.25) ÷ 80 = 6 ÷ 80 = 0.075, or 7.5%.
Total value = 12,000,000 + 2,400,000 = ₹14,400,000.
Weighted cost = (12,000,000 × 0.113) + (2,400,000 × 0.075) = 1,356,000 + 180,000 = 1,536,000.
WACC = 1,536,000 ÷ 14,400,000 = 0.10667, or 10.7%.

Answer: WACC is about 10.7%.

Example 2

Beta Co has equity with a market value of ₹9 million and 6% redeemable loan notes with a market value of ₹3 million. The risk-free rate is 4%, the market return is 10% and Beta's equity beta is 1.2. The after-tax cost of the loan notes is 5%. Calculate the WACC.

Show the solution

Ke by CAPM = 4% + 1.2 × (10% − 4%) = 4% + 7.2% = 11.2%.
Total value = 9 + 3 = ₹12 million.
Equity weight = 9 ÷ 12 = 0.75. Debt weight = 3 ÷ 12 = 0.25.
WACC = (0.75 × 11.2%) + (0.25 × 5%) = 8.4% + 1.25% = 9.65%.

Answer: WACC is 9.65%.

Exam tips

In objective questions, check the units. Market value may be given per share or per ₹100 nominal, and you must scale it correctly.
Always read whether the share price is cum-div or ex-div, and whether the dividend given is D0 or D1.
In a constructed response question, lay out the WACC in a table with value, cost and weighted cost. Markers can then award marks for each step.
Add a short comment on limits: WACC assumes constant risk and capital structure, and market values change daily. These points often earn marks.
If the question asks for the cost of debt, show the interpolation for redeemable debt in full. Marks are given for both discount rates tried.

Practice questions from Capital structure theories and practical considerations

Cost of Capital and WACC Recap 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 and WACC Recap: frequently asked questions

Why do we use market values instead of book values in WACC?

Market values show what investors would pay for each source of finance today, so they reflect the current claims on the company. Book values reflect past issue prices and accounting entries. Use book values only when market values are not given.

Why is the cost of equity higher than the cost of debt?

Shareholders are paid after lenders and their dividends are not guaranteed. They carry more risk, so they require a higher return. Debt interest is also tax deductible, which lowers its cost further.

Do I adjust preference share cost for tax?

No. Preference dividends are paid from profit after tax, so they give no tax saving. Use dividend ÷ market price.

When is WACC not the right discount rate?

WACC is not suitable if the project has different business risk from the company, or if the project is financed in a way that changes the capital structure. In those cases you should adjust the rate or use another approach.