CA Intermediate · Financial Management and Strategic Management
Cost of Capital for CA Intermediate Financial Management
Cost of capital is the minimum return a firm must earn on an investment to keep its investors satisfied. To solve questions, find the cost of each source (debt, preference, equity, retained earnings), then weight them by value to get WACC. Use after-tax cost for debt.
What this chapter covers
This chapter in Paper 6 Section A (Financial Management) teaches you how to measure what each source of finance costs a company. You calculate the cost of debt, preference shares, equity and retained earnings, then combine them into a weighted average cost of capital (WACC) and a marginal cost of capital.
The chapter is formula-driven, so it suits step-wise marking. Most questions give you a capital structure with a few rates and ask for one or two costs and the WACC. Interpretation of the result is often a small part of the answer.
It links directly to other chapters. WACC is the discount rate in capital budgeting (NPV, IRR). It also feeds into capital structure theories and leverage, where you judge how debt changes cost and risk. Learn this chapter well and those chapters become easier.
Cost of capital is a high-scoring, predictable chapter because the methods are fixed and the working earns step marks even if one number slips. It also appears as a building block inside capital budgeting and capital structure questions, so one solid grasp pays off in several places. MCQs test single formulas quickly, and the written questions reward a clean table of weights, costs and weighted costs. With no negative marking in MCQs, speed on these formulas also lets you attempt every question.
Cost of Capital: topics in the order to study them
- 1Cost of Capital: Meaning and SignificanceStart here to understand what the cost means, why it is a required return, and how it is used in decisions, before any formula.
- 2Cost of Debt (Debentures, Bonds and Term Loans)It is the simplest component and introduces the tax adjustment, issue costs and redemption, which you use throughout.
- 3Cost of Preference Share CapitalIt follows the same logic as debt but with no tax shield, so you can compare the two and avoid mixing them up.
- 4Cost of Equity Share Capital (Dividend, CAPM, Earnings Models)This is the hardest component with several methods, so study it once the simpler costs are fluent.
- 5Cost of Retained EarningsIt builds on the cost of equity and mainly needs you to see when floatation costs do and do not apply.
- 6Weighted Average Cost of Capital (WACC)It combines all earlier costs, so you need each component right first. Practise book value and market value weights.
- 7Marginal Cost of CapitalIt extends WACC to new funds raised, so study it last, once the WACC table method is automatic.
How to prepare Cost of Capital
Treat this as a formula-and-practice chapter. Aim to move from knowing each formula to producing a clean table under time pressure.
- Write one formula sheet with Kd, Kp, Ke (dividend growth, CAPM, earnings) and WACC, noting which ones use the tax rate and which use net proceeds.
- Learn the conditions for each formula, such as when to use the net proceeds and when to use face value, and whether the tax shield applies.
- Solve two or three questions per component before moving on. Always compute the cost before you worry about weights.
- Practise WACC with both book value and market value weights. Set out a table with source, amount, weight, cost and weighted cost, then total it.
- Do marginal cost questions by working out the weights of the new funds and the cost of each new source, and find the cost at each financing slab.
- Finish with mixed MCQs under a timer, then redo the written questions you got wrong after a gap of a few days.
Common mistakes in Cost of Capital
Using the pre-tax cost of debt in WACC.
Fix: Multiply by (1 − t) every time debt enters WACC, and tick this off in your table.
Applying a tax adjustment to preference share cost.
Fix: Remember that preference dividend is paid from after-tax profit, so no tax shield applies.
Using D0 instead of D1 in the dividend growth model.
Fix: Check if the dividend given is already paid or expected. If paid, compute D1 = D0 × (1 + g).
Mixing book value and market value weights in one table.
Fix: Choose one basis, convert all sources to it, and write the basis above the table.
Ignoring issue costs or using face value instead of net proceeds.
Fix: Underline the issue price and floatation cost, and compute net proceeds first.
Adding costs directly instead of weighting them.
Fix: Always multiply each cost by its weight and then sum, or divide by total funds.
Last-day revision: Cost of Capital
- Cost of capital is the minimum required return that keeps investors satisfied.
- After-tax cost of debt = Interest × (1 − t) ÷ Net proceeds, in the simple perpetual case.
- Interest on debt is tax deductible. Preference dividend is not, so there is no tax shield on Kp.
- Use net proceeds (after issue cost) for the cost of new debt, preference and new equity.
- Kp for irredeemable preference = Preference dividend ÷ Net proceeds.
- Dividend growth model: Ke = D1 ÷ P0 + g, where D1 = D0 × (1 + g).
- CAPM: Ke = Rf + β × (Rm − Rf).
- Earnings model: Ke = E ÷ P, used when earnings are expected to stay constant.
- Retained earnings have no floatation cost, so their cost equals Ke on existing shares.
- WACC = Σ (weight × cost) ÷ Σ weights, using after-tax costs.
- Prefer market value weights for decisions and state clearly which weights you used.
- Marginal cost of capital is the weighted cost of the next rupee raised, using target weights.
Cost of Capital practice questions
- Kaveri Industries Ltd has 12% irredeemable debentures of Rs 1,000 face value issued at par. Floatation cost is nil and the tax rate is 25%. …
- Nirmal Textiles Ltd has 9% preference shares of face value ₹100, issued at par, redeemable at par after 10 years. Flotation cost is ignored.…
- Meera Foods Ltd's equity share has a beta of 1.2. The risk-free rate is 7% and the expected market return is 13%. Using CAPM, what is the co…
- Which one of the following is generally treated as the cost of retained earnings under the dividend growth approach, assuming no personal ta…
- Aarav Textiles Ltd issued 10% preference shares of face value ₹100 each, redeemable at par after 5 years, at a price of ₹100 per share. Flot…
- Which of the following is the correct statement about the cost of retained earnings in the context of cost of capital?
- Tanishq Components Ltd expects a dividend of ₹6 per share next year. The current market price is ₹100 and dividends are expected to grow at …
- Meridian Pharma Ltd has issued 12% irredeemable preference shares of face value ₹100 each at par. Flotation cost is ignored. What is the cos…
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.
Cost of Capital: frequently asked questions
Which formula should I use for cost of equity?
Use the method that fits the data given. If dividends and growth are given, use the dividend growth model. If beta and market returns are given, use CAPM. If only earnings and price are given, use the earnings model.
Should I use book value or market value weights in WACC?
Follow the question. If it asks for one basis, use it. If it gives both and does not specify, market value weights are generally preferred, as they reflect current investor expectations. State your choice in the answer.
Is cost of retained earnings the same as cost of equity?
In most exam questions, yes, because retained earnings carry no floatation cost. The cost of new equity shares can be higher if issue costs are given. Check the data before you decide.
How do I score step marks in WACC questions?
Show the cost of each source with its formula, then a table with amount, weight, cost and weighted cost. Total the weighted costs and state the WACC as a percentage. Even if one cost is wrong, the method marks remain.