Business Finance · Cost of capital and evaluating investment projects

Cost of Equity and Cost of Debt Explained

Q: How do I calculate cost of equity using CAPM?

Use Ke = Rf + β × (Rm − Rf). Take the risk-free rate, then add beta times the market risk premium. For example, Rf 6%, beta 1.2 and premium 6% give 13.2%.

Q: What is the difference between cost of equity and cost of debt?

Cost of equity is the return shareholders require, and it must be estimated from market data. Cost of debt is the return lenders require, found from interest and the bond yield. Equity is riskier, so it usually costs more. Debt also gets a tax shield.

Q: Why is cost of debt reduced by tax?

Interest is deductible when working out taxable profit. Each rupee of interest reduces tax by t rupees. So the real cost to the company is Kd × (1 − t), provided the company has enough profit to use the deduction.

Q: When should I use the dividend growth model rather than CAPM?

Use the dividend growth model when you are given dividends, growth and a share price. Use CAPM when you are given beta and market return data. If both are available, compute both and comment on any difference.

Updated 11 October 2026 · Fact-checked

The cost of equity is the return shareholders require. You estimate it with the dividend growth model, Ke = D1 ÷ P0 + g, or CAPM, Ke = Rf + β(Rm − Rf). The cost of debt is the return lenders require, Kd. Interest is tax deductible, so after-tax Kd = Kd × (1 − t).

Understand Cost of Equity and Cost of Debt

A company raises money from shareholders and lenders. Each group wants a return for the risk it takes. That required return is the cost of capital for that source. The company must earn at least this much on a project, or it destroys value.

Cost of equity is the return shareholders expect. It is not a payment the company must make, so you cannot read it from the accounts. You estimate it from market data. Two common methods are the dividend growth model and the Capital Asset Pricing Model (CAPM).

The dividend growth model says a share price equals the present value of its future dividends. If dividends grow at a constant rate g forever, then P0 = D1 ÷ (Ke − g). Rearranged, Ke = D1 ÷ P0 + g. CAPM instead links the required return to systematic risk. Beta measures how much the share moves with the market. A higher beta means a higher required return.

Cost of debt is the return lenders require. For a bond, it is the yield to maturity: the rate that makes the present value of interest and redemption equal to the market price. Equity is riskier than debt, because shareholders are paid last. So the cost of equity is normally higher than the cost of debt.

Interest is an allowable expense when computing taxable profit, so debt gives a tax shield. The company's real cost is lower than the interest rate. After-tax cost of debt is Kd × (1 − t). Dividends get no such relief. Always say whether a rate is before or after tax.

Key rules to remember

Dividend growth model (cost of equity): Ke = D1 ÷ P0 + g; Assumes dividends grow at a constant rate g forever and g < Ke. P0 is the ex-dividend price. D1 = D0 × (1 + g).
Share price from dividend growth: P0 = D1 ÷ (Ke − g); Same model, rearranged. Use it to find price when Ke is known.
Estimating growth from past dividends: g = (D_n ÷ D_0)^(1/n) − 1; Use the number of growth periods n, which is one fewer than the number of dividends listed.
Gordon growth with retention: g = b × r; b is the proportion of earnings retained. r is the return on retained funds. Assumes both stay constant.
CAPM: Ke = Rf + β × (Rm − Rf); Rf is the risk-free rate. Rm − Rf is the market risk premium. β measures systematic risk only.
Cost of irredeemable debt (before tax): Kd = I ÷ P0; I is annual interest. P0 is the ex-interest market price.
After-tax cost of debt: Kd(after tax) = Kd × (1 − t); Applies when the company pays tax and can use the interest deduction. t is the corporate tax rate.
Cost of redeemable debt: P0 = Σ I(1 − t) ÷ (1 + Kd)^k + R ÷ (1 + Kd)^n; Solve for Kd using interpolation or trial rates. Use I(1 − t) for after-tax cost. Redemption value R is usually not taxed.

How to solve Cost of Equity and Cost of Debt questions

Use this method for any question that asks for a cost of equity or cost of debt.

1Read what is asked: cost of equity or debt, and before or after tax.
2List the data given: prices, dividends, growth, beta, Rf, Rm, interest, redemption terms, tax rate.
3Pick the method. Dividend data and price point to dividend growth. Beta and market returns point to CAPM. Bond data points to yield.
4Check the timing. For dividend growth, use next year's dividend D1. If you are given D0, multiply by (1 + g).
5Substitute carefully. Convert percentages to decimals. Use ex-dividend or ex-interest prices.
6For debt, apply the tax adjustment: multiply by (1 − t), or use I(1 − t) in the redeemable debt equation.
7For redeemable debt, try two discount rates, then interpolate linearly to find the yield.
8State the answer with units and basis, for example 'cost of equity 12.5% a year' or 'after-tax cost of debt 5.6%'. Note any assumption, such as constant growth.

Quickest way: Pick the formula from the data

When to use it: Use this when time is short, especially in multiple-choice questions.

Beta or market return given: use CAPM and compute Rf + β(Rm − Rf).
Dividend and price given: compute D1 ÷ P0 + g. Grow D0 first if needed.
Irredeemable debt: Kd = I ÷ P0, then × (1 − t).
Redeemable debt: guess a rate near the coupon yield, check the value, then interpolate once.
Do a sense check: Ke should be above Kd, and after-tax Kd should be below before-tax Kd.

Common mistakes in Cost of Equity and Cost of Debt

Using D0 instead of D1 in the dividend growth model.
The latest dividend is the one you are given, so it feels natural to use it.
Fix: Always check which dividend is stated. If it is the dividend just paid, compute D1 = D0 × (1 + g) before dividing by P0.
Forgetting to add g after D1 ÷ P0.
Students stop at the dividend yield and treat it as the full return.
Fix: Write Ke = yield + growth every time. The return has an income part and a growth part.
Using the market return Rm instead of the premium Rm − Rf in CAPM.
The two quantities are easy to confuse when a question states them close together.
Fix: Read carefully. If 'market return' is given, subtract Rf. If 'risk premium' is given, use it directly.
Applying the tax shield to the cost of equity.
Students remember 'tax adjustment' and apply it to every cost.
Fix: Only interest is tax deductible. Dividends are paid from profit after tax, so equity costs are not reduced by (1 − t).
Taxing the redemption value of a bond.
Students multiply every cash flow by (1 − t).
Fix: Adjust only the interest payments, unless the question states that redemption proceeds are taxed. State your assumption.
Using the coupon rate as the cost of debt.
The coupon is the easiest rate to see in the question.
Fix: Use the market yield. The cost is set by the current market price, not by the rate printed on the bond.

Worked examples

Example 1

A company's share price is ₹250 ex-dividend. It has just paid a dividend of ₹20 per share. Dividends are expected to grow at 5% a year indefinitely. Estimate the cost of equity using the dividend growth model. Then check it against CAPM, given a risk-free rate of 6%, a market return of 12% and a beta of 1.2.

Show the solution

Find next year's dividend: D1 = 20 × 1.05 = ₹21.
Dividend yield = 21 ÷ 250 = 0.084, or 8.4%.
Ke = 8.4% + 5% = 13.4%.
CAPM: market risk premium = 12% − 6% = 6%.
Ke = 6% + 1.2 × 6% = 6% + 7.2% = 13.2%.
The two estimates are close, 13.4% and 13.2%. They use different assumptions, so they will rarely match exactly.

Answer: Dividend growth gives a cost of equity of 13.4%. CAPM gives 13.2%.

Example 2

A company has irredeemable debentures with annual interest of ₹9 per ₹100 nominal. The market price is ₹90 ex-interest. The tax rate is 25%. Find the before-tax and after-tax cost of debt. Then find the after-tax cost of a one-year bond bought at ₹95 that pays interest of ₹8 and redeems at ₹100 after one year, assuming the same tax rate and that redemption is not taxed.

Show the solution

Irredeemable debt: Kd = I ÷ P0 = 9 ÷ 90 = 0.10, or 10% before tax.
After tax: 10% × (1 − 0.25) = 7.5%.
One-year bond: the after-tax interest is 8 × (1 − 0.25) = ₹6.
Cash received at the end of the year = 6 + 100 = ₹106.
Solve 95 = 106 ÷ (1 + Kd). So 1 + Kd = 106 ÷ 95 = 1.11579.
Kd = 11.58% after tax, to two decimal places.

Answer: Irredeemable debt: 10% before tax and 7.5% after tax. One-year bond: about 11.58% after tax, since the ₹5 gain on redemption is not taxed.

Exam tips

Read whether the price is cum or ex dividend or interest. Adjust it if needed before using the formula.
Show the formula in symbols first, then your numbers. Written answers give method marks even if the arithmetic slips.
In discussion parts, explain why Ke is above Kd: equity holders carry more risk and are paid last.
State your assumptions, such as constant growth or a stable beta. Examiners reward this.
For redeemable debt, set out the two trial rates in a small table and interpolate. Do not skip this working.

Practice questions from Cost of capital and evaluating investment projects

Cost of Equity and Cost of Debt 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 Equity and Cost of Debt: frequently asked questions

How do I calculate cost of equity using CAPM?

Use Ke = Rf + β × (Rm − Rf). Take the risk-free rate, then add beta times the market risk premium. For example, Rf 6%, beta 1.2 and premium 6% give 13.2%.

What is the difference between cost of equity and cost of debt?

Cost of equity is the return shareholders require, and it must be estimated from market data. Cost of debt is the return lenders require, found from interest and the bond yield. Equity is riskier, so it usually costs more. Debt also gets a tax shield.

Why is cost of debt reduced by tax?

Interest is deductible when working out taxable profit. Each rupee of interest reduces tax by t rupees. So the real cost to the company is Kd × (1 − t), provided the company has enough profit to use the deduction.

When should I use the dividend growth model rather than CAPM?

Use the dividend growth model when you are given dividends, growth and a share price. Use CAPM when you are given beta and market return data. If both are available, compute both and comment on any difference.