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Business Finance · Structure and methods of financing a company

Cost of Capital and WACC: How to Calculate It

Updated 11 October 2026 · Fact-checked

Cost of capital is the return a company must earn to satisfy its investors. WACC is the average of the costs of equity, debt and other finance, weighted by market value: WACC = Σ (weight × after-tax cost). Find each cost, find market-value weights, then add up the weighted costs.

Understand Cost of Capital and WACC

Every company raises money from investors. Investors want a return for the risk they take. From the company's side, that required return is its cost of capital. A project is worth doing only if it earns at least this much.

Different sources of finance cost different amounts. Debt is cheaper than equity. Lenders have a legal claim to interest and capital, and they rank ahead of shareholders if the company fails. So lenders accept a lower return. Shareholders get paid last and carry more risk, so they demand a higher return. That is the core difference between the cost of equity and the cost of debt.

Interest on debt is usually tax-deductible, so the company's real cost of debt is lower than the interest rate. Dividends are paid out of profit after tax and give no such saving. This is why you use the after-tax cost of debt in WACC.

A company usually uses a mix of sources. The weighted average cost of capital (WACC) combines the costs of each source, weighted by its share of total financing. Use market values for weights, not book values, because market values show what investors currently require and what the company would have to pay to raise money now.

WACC is used as the discount rate for projects whose risk is similar to the company's existing business and whose financing mix stays about the same. If a project has different risk, WACC is not the right rate. Use a rate that fits the project's risk.

Key rules to remember

Cost of equity (dividend growth model)
Ke = D1 ÷ P0 + g
D1 is next year's dividend, P0 is the current ex-dividend share price, g is the constant annual dividend growth rate. Valid when growth is constant and g < Ke.
Cost of equity (CAPM)
Ke = Rf + β × (Rm − Rf)
Rf is the risk-free rate, β is the equity beta, (Rm − Rf) is the market risk premium.
After-tax cost of debt (irredeemable)
Kd = i × (1 − t)
Here i is the pre-tax cost of debt (the yield, or interest ÷ market price), and t is the corporate tax rate. Assumes the company pays tax and gets relief at once.
Cost of redeemable debt
Solve: P0 = Σ I × (1 − t) ÷ (1 + Kd)^n + R ÷ (1 + Kd)^N
Kd is the IRR of the after-tax cash flows: market price paid in, after-tax interest and redemption value paid out. Use two trial rates and interpolate.
Cost of irredeemable preference shares
Kp = D ÷ P0
D is the fixed annual preference dividend and P0 is the market price. No tax adjustment.
WACC
WACC = (E × Ke + D × Kd + P × Kp) ÷ (E + D + P)
E, D and P are market values of equity, debt and preference shares. Kd must be the after-tax cost.

How to solve Cost of Capital and WACC questions

Use this order for any cost of capital or WACC question. It stops you mixing up costs and weights.

  1. 1List every source of finance in the question: ordinary shares, preference shares, bonds, loans.
  2. 2Find the market value of each source. Use market price × number of units. Use book value only if no market value is given, and say so.
  3. 3Calculate the cost of equity. Use the dividend growth model if dividend data is given, or CAPM if a beta and market data are given.
  4. 4Calculate the cost of each debt source. Find the pre-tax yield, then multiply by (1 − t). For redeemable debt, find the IRR of the after-tax cash flows.
  5. 5Calculate the cost of preference shares if any. Do not adjust for tax.
  6. 6Work out the weights: each market value divided by total market value of finance.
  7. 7Multiply each cost by its weight and add. State the WACC as a percentage.
  8. 8Comment on use: WACC suits projects of average company risk and unchanged financing mix. Say what would change the answer.

Quickest way: Table method for WACC

When to use it: Use this when the question gives all the costs and values and asks only for WACC. It works well in the MCQ section and for short written parts.

  1. Draw three columns: market value, after-tax cost, value × cost.
  2. Fill in each source on one row. Convert debt cost to after-tax before you enter it.
  3. Add the market value column to get total finance.
  4. Add the third column and divide by the total. The result is WACC.
  5. Sense check: WACC must lie between the lowest and highest cost, and closer to the cost of the larger source.

Common mistakes in Cost of Capital and WACC

  • Using the pre-tax cost of debt in WACC

    The interest rate is given in the question, so it is quick to plug in.

    Fix: Always multiply by (1 − t) before the weighting step. Write 'Kd after tax' in your table header.

  • Using book values as weights

    Balance sheet figures are easy to find and look official.

    Fix: Use market values of shares and debt. Use book values only when market values are not available, and state that assumption.

  • Using the current dividend D0 instead of D1 in the growth model

    Students forget the formula needs next year's dividend.

    Fix: Compute D1 = D0 × (1 + g) first, then divide by P0.

  • Adjusting preference share cost for tax

    Preference shares look like debt because of the fixed payment.

    Fix: Preference dividends are paid from after-tax profit, so use D ÷ P0 with no tax adjustment.

  • Calculating cost of debt as interest ÷ nominal value

    Coupon and nominal value are the numbers most visible in the question.

    Fix: Cost of debt is the yield based on current market price. Use coupon ÷ market price for irredeemable debt, or the IRR for redeemable debt.

  • Using WACC for every project

    WACC feels like the standard discount rate.

    Fix: Say that WACC applies only when project risk and financing mix match the company's. Otherwise adjust the rate for the project's risk.

Worked examples

Example 1

A company has 20 lakh ordinary shares priced at ₹50 each. The next dividend is ₹4 per share and dividends grow at 6% a year. It also has ₹40,00,000 market value of 8% irredeemable debentures trading at par. The tax rate is 25%. Calculate the WACC.

Show the solution
  1. Market value of equity = 20,00,000 × ₹50 = ₹10,00,00,000.
  2. Cost of equity: Ke = 4 ÷ 50 + 0.06 = 0.08 + 0.06 = 14%.
  3. Debt trades at par, so the pre-tax cost is 8%. After tax: Kd = 8% × (1 − 0.25) = 6%.
  4. Total market value = ₹10,00,00,000 + ₹40,00,000 = ₹10,40,00,000.
  5. Weights: equity = 10,00,00,000 ÷ 10,40,00,000 = 0.96154. Debt = 0.03846.
  6. WACC = 0.96154 × 14% + 0.03846 × 6% = 13.4615% + 0.2308% = 13.69%.

Answer: WACC ≈ 13.69%.

Example 2

A company has equity worth ₹60 crore and 9% irredeemable bonds worth ₹30 crore at market value, with a pre-tax yield of 10%. Preference shares worth ₹10 crore pay a 12% dividend on market value. The risk-free rate is 6%, the market return is 12%, the equity beta is 1.2 and the tax rate is 30%. Calculate the WACC and explain one limitation of using it.

Show the solution
  1. Cost of equity by CAPM: Ke = 6% + 1.2 × (12% − 6%) = 6% + 7.2% = 13.2%.
  2. After-tax cost of debt: the market yield is 10%, so Kd = 10% × (1 − 0.30) = 7%.
  3. Preference share cost = 12% (the dividend is given on market value, no tax adjustment).
  4. Total value = 60 + 30 + 10 = ₹100 crore. Weights: equity 0.6, debt 0.3, preference 0.1.
  5. WACC = 0.6 × 13.2% + 0.3 × 7% + 0.1 × 12% = 7.92% + 2.10% + 1.20% = 11.22%.
  6. Limitation: WACC assumes the project has the same risk as the company and the financing mix stays constant. A project in a riskier business should be discounted at a higher rate.

Answer: WACC = 11.22%. It is only valid for projects with similar risk and unchanged financing mix.

Exam tips

  • Show a clear table of values, costs and weights. Marks are given for method even if one input is wrong.
  • Read the question for the word 'market' or 'book'. The weights depend on it.
  • In MCQs, check whether the debt cost given is already after tax. Examiners often include the pre-tax figure as a trap.
  • In written parts, add a line on assumptions: constant growth, constant gearing, tax paid in full. State them before you calculate.
  • Be ready to explain why equity costs more than debt. This short theory point often earns easy marks.

Practice questions from Structure and methods of financing a company

Cost of Capital and WACC 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: frequently asked questions

How do I calculate WACC with an example?

Find the cost of each source, convert debt to after-tax, then weight each by market value. For example, equity of ₹100 at 14% and debt of ₹50 at 6% after tax gives (100 × 14% + 50 × 6%) ÷ 150 = 11.33%.

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

Cost of equity is the return shareholders require, and it is higher because shareholders carry more risk and are paid last. Cost of debt is the return lenders require, and it is lower. Interest is also tax-deductible, which lowers the effective cost of debt further.

How do I calculate the cost of debt after tax?

Find the pre-tax yield on the debt, then multiply by (1 − tax rate). For redeemable debt, find the IRR of the after-tax cash flows using the market price, after-tax interest and redemption value.

Should I use market or book values for WACC weights?

Use market values. They show what investors require now. Use book values only when market values are not given, and state that you have done so.