Cost of Capital and WACC: How to Calculate It

Understand Cost of Capital and WACC

Key rules to remember

Dividend growth model (cost of equity)

Ke = D1 ÷ P0 + g, where D1 = D0 × (1 + g)

P0 is the ex-dividend price. Assumes dividends grow at a constant rate g forever.

CAPM (cost of equity)

Ke = Rf + β × (Rm − Rf)

(Rm − Rf) is the market risk premium. Use the equity beta, which reflects gearing.

Cost of irredeemable debt (after tax)

Kd = i × (1 − T) ÷ P0, where i is the annual interest per ₹100 nominal

P0 is the ex-interest market price per ₹100 nominal. T is the corporate tax rate.

Cost of redeemable debt

Find r so that P0 = Σ i(1 − T) ÷ (1 + r)^t + Redemption ÷ (1 + r)^n; then Kd = r

Use after-tax interest in the cash flows. Solve by trial and interpolation between two rates.

WACC

WACC = [E × Ke + D × Kd(1 − T)] ÷ (E + D)

If Kd is the pre-tax yield, apply (1 − T). If you already have the after-tax cost, do not apply it again. E and D are market values.

Growth from retained earnings

g = b × r

b is the retention ratio and r is the return on retained funds. A simple estimate that assumes both stay constant.

How to solve Cost of Capital and WACC questions

1. 1List the data given: share price, dividends, growth, beta, risk-free rate, market return, debt price, coupon, redemption, tax rate and number of securities.
2. 2Check whether prices are cum or ex dividend or interest. Adjust if needed before using them.
3. 3Calculate the cost of equity with the model the question names. If none is named, choose one and state why.
4. 4Calculate the cost of debt. Use the yield on market price and then apply (1 − T) once.
5. 5Calculate market values: number of shares × share price for equity, and number of bonds × market price for debt.
6. 6Work out the weights as each market value divided by the total.
7. 7Compute WACC as the sum of weight × cost for each source. Show it to two decimal places in percent.
8. 8State the assumptions and say whether WACC is suitable as the project discount rate.

Quickest way: Table method for WACC

Common mistakes in Cost of Capital and WACC

• Using book values as weights

  Balance sheet figures are easy to see and the question may list them first.

  Fix: Use market values unless the question says otherwise. Compute shares × price and debt × market price.

• Forgetting the tax adjustment on debt, or applying it twice

  Students lose track of whether the yield they found already includes tax.

  Fix: Write 'pre-tax' or 'post-tax' beside each debt figure. Apply (1 − T) exactly once, and only to the interest cash flows or the final yield.

• Using D0 instead of D1 in the dividend growth model

  The most recent dividend is the one quoted.

  Fix: Compute D1 = D0 × (1 + g) first. Use D1 in the formula unless the question gives next year's dividend directly.

• Applying tax relief to the cost of equity

  Students link 'cost of capital' with 'tax shield' for all sources.

  Fix: Dividends are paid from after-tax profit. Only interest gives the tax shield.

• Using the market return instead of the risk premium in CAPM

  Rm and (Rm − Rf) look alike in the data.

  Fix: Subtract Rf from Rm before multiplying by β, then add Rf back. Check: if β = 1, Ke equals Rm.

• Using WACC for every project

  It is taught as the standard discount rate.

  Fix: Say that WACC applies only if business risk matches the firm's and gearing stays broadly constant. Otherwise use a risk-adjusted rate.

Worked examples