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Sources of Finance and Cost of Capital for ACCA SBL

Updated 11 October 2026 · Fact-checked

Sources of finance are the ways a business funds itself, mainly debt and equity. Cost of capital is the return each provider requires. WACC blends these costs by market-value weights. To solve questions, cost each source, weight it, then judge how the financing mix affects risk, value and investment decisions.

Understand Sources of Finance and Cost of Capital

A business needs money to operate and grow. It gets it from equity (owners' money, from share issues or retained earnings) or debt (loans, bonds, leases). Each provider wants a return for the risk taken. That required return is the cost of capital to the company.

Debt is usually cheaper than equity. Lenders are paid first, often hold security, and receive fixed interest. Interest is also tax-deductible in most tax systems, which lowers the cost after tax. But debt must be serviced whatever the profits. Too much debt raises financial risk and the chance of distress.

Equity has no fixed payment and no repayment date, so it is safer for the company. But shareholders carry the most risk, so they demand the highest return. Retained earnings are not free. They have an opportunity cost equal to the shareholders' required return. Issuing new shares may dilute control and bring issue costs.

The weighted average cost of capital (WACC) combines the costs of each source, weighted by market value. Companies use it as the discount rate for projects with similar business risk and similar financing. If a project's return beats its cost of capital, it should add value.

Capital structure theory asks whether the mix of debt and equity changes company value. Modigliani and Miller (M&M) said that with no taxes, value is independent of the mix. With corporate tax, debt adds value through the tax shield. Real-world costs of distress, agency costs and pecking order behaviour (retained earnings first, then debt, then new equity) explain why firms do not simply use maximum debt. In SBL, the numbers are only support. You must advise on the strategic choice.

Key rules to remember

WACC: WACC = [E ÷ (E + D)] × Ke + [D ÷ (E + D)] × Kd × (1 − t); Use market values for E and D. Kd is the pre-tax cost of debt. t is the tax rate.
Cost of equity (dividend growth model): Ke = [D0 × (1 + g) ÷ P0] + g; P0 is the ex-dividend share price. D0 is the dividend just paid.
Cost of equity (CAPM): Ke = Rf + β × (Rm − Rf); Rm − Rf is the market risk premium. Beta reflects systematic risk.
Post-tax cost of irredeemable debt: Kd = [Interest × (1 − t)] ÷ Market value of debt; For redeemable debt, use the IRR of the cash flows instead.
M&M with tax (proposition 1): Vg = Vu + D × t; Geared value equals ungeared value plus the tax shield on permanent debt. It assumes perfect markets, ignoring distress costs.
Gearing ratio (market value): Debt ÷ (Debt + Equity) or Debt ÷ Equity; State which version you use.

How to solve Sources of Finance and Cost of Capital questions

Use this method for any question on funding choices or cost of capital. Do the numbers briefly, then spend most time on advice.

1Read the requirement. Decide whether it asks for a calculation, a recommendation, or both.
2Identify the company's current funding, gearing, cash flow stability and the purpose of the money in the scenario.
3Cost each source: Ke by DGM or CAPM, Kd after tax. Use market values for weights.
4Calculate WACC and show the working clearly so you earn method marks.
5Test the effect of the new funding on gearing, WACC, interest cover and earnings per share.
6Link to theory: M&M, tax shield, distress costs, pecking order. Use only what fits the facts.
7Recommend a source and justify it with scenario facts: risk, control, cost, covenants, timing.
8State limits and assumptions, such as constant growth, stable risk and tax rate.

Quickest way: Five-line WACC and advice routine

When to use it: Use when time is short and the question gives clean cost and value data.

Write market values of equity and debt and total them.
Compute weights as fractions of the total.
Compute Ke and post-tax Kd on one line each.
Multiply and add to get WACC.
Write two or three points on risk, control and cost that apply to this company, then conclude.

Common mistakes in Sources of Finance and Cost of Capital

Using book values for the weights.
The balance sheet is the first place students look.
Fix: Use market values of shares and debt unless the question gives no choice. Say so if you must use book values.
Forgetting to adjust debt for tax.
Students remember interest rates but not the tax shield.
Fix: Multiply the pre-tax cost of debt by (1 − t) before weighting.
Treating retained earnings as free.
No cash payment is visible.
Fix: Remember shareholders expect a return on retained funds. Use Ke.
Saying debt is always best because it is cheaper.
Students stop at the WACC calculation.
Fix: Add financial risk, covenants, distress costs and cash flow volatility. Cheap debt raises the cost of equity.
Applying the company WACC to a project with different risk.
WACC is treated as a universal rate.
Fix: Say WACC applies only if business risk and gearing are unchanged. Otherwise adjust the rate.
Giving theory without the scenario.
Students recite M&M from memory.
Fix: Tie each theory point to a fact in the case, such as stable cash flows or a tight loan covenant.

Worked examples

Example 1

A company has 10 million shares at a market price of $3.00 each (ex-dividend). The dividend just paid was $0.24 per share, and dividends are expected to grow at 5% a year. It also has $12 million of 8% irredeemable bonds trading at par. Tax is 25%. Calculate the WACC.

Show the solution

Market value of equity = 10m × $3.00 = $30m. Debt = $12m. Total = $42m.
Equity weight = 30 ÷ 42 = 0.7143. Debt weight = 12 ÷ 42 = 0.2857.
Ke = [0.24 × 1.05 ÷ 3.00] + 0.05 = 0.084 + 0.05 = 0.134, or 13.4%.
Post-tax Kd = 8% × (1 − 0.25) = 6.0%.
WACC = 0.7143 × 13.4% + 0.2857 × 6.0% = 9.571% + 1.714% = 11.29%.

Answer: WACC is about 11.3%.

Example 2

A manufacturer with steady cash flows plans a $20 million plant expansion. Its gearing is low. The board is split between a rights issue and a bank loan. Advise the board.

Show the solution

Note the facts: steady cash flows and low gearing mean the company can carry more debt safely.
Cost: debt is cheaper than equity and interest is tax-deductible. Replacing some equity-funded capital with debt should lower WACC at this low level of gearing.
Theory: M&M with tax says the tax shield adds value. Distress costs are small while gearing is low and cash flows are stable.
Risk: a loan brings fixed interest and possible covenants. Check interest cover on the expansion's forecast profits.
Control: a rights issue offers shares pro rata to existing holders, so control is kept if they take it up. But it costs more in issue costs and may signal that shares are overvalued.
Pecking order supports debt before new equity when internal funds are not enough.
Recommend mainly bank debt, but cap gearing and keep headroom on covenants. Consider a mix if the loan would push gearing above the level lenders tolerate.

Answer: Recommend mainly debt. It is cheaper, uses the tax shield, avoids dilution and suits steady cash flows. Set limits on gearing and interest cover. Use some equity if covenants or risk become too tight.

Exam tips

Do not spend more than a third of your time on the calculation. SBL rewards advice and judgement.
Always show the formula and the weights. A small slip still earns method marks.
Tie every point to the scenario, such as sector, cash flow stability, owners' attitude to control and existing loan terms.
Show professional skills: give a clear recommendation, note the assumptions and mention what you would check next.
Say which cost of equity model you used and why, and warn that its inputs are estimates.

Practice questions from Financial analysis and decision-making techniques

Sources of Finance and Cost of Capital in other exams

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

Sources of Finance and Cost of Capital: frequently asked questions

How do I calculate WACC in the ACCA exam?

Find market values of equity and debt, then weights. Work out Ke and post-tax Kd. Multiply each cost by its weight and add. Show each step clearly.

What is the difference between debt and equity financing?

Debt is borrowed money with fixed interest, a repayment date and a lender's claim ahead of shareholders. Equity is owners' capital with no fixed return or repayment. Debt is usually cheaper but riskier for the company.

What do Modigliani and Miller say about capital structure?

Without taxes and in perfect markets, they say value does not depend on the debt-equity mix. With corporate tax, debt adds value through the tax shield. In real markets, distress and agency costs limit how much debt is wise.

Is the cost of retained earnings zero?

No. Shareholders could have received the cash and invested it elsewhere, so retained earnings carry the cost of equity. Treat them as equity at Ke.