Financial Management and Strategic Management · Financing Decisions - Capital Structure

Cost of Capital Components: Debt, Preference, Equity and Retained Earnings

Updated 4 October 2026 · Fact-checked

Cost of capital components are the required returns on each source of long-term finance: debt, preference shares, equity and retained earnings. You compute each one separately, adjust debt for tax, use net proceeds after issue costs where asked, and then feed the results into WACC for capital structure decisions.

Understand Cost of Capital Components

Every rupee a company raises has a price. Lenders want interest, preference holders want a fixed dividend, and equity holders want returns for bearing risk. The cost of capital of a source is the minimum return the company must earn on money raised from it, so that the investors stay satisfied.

You compute the cost of each source separately. These are the components: cost of debt (Kd), cost of preference shares (Kp), cost of equity (Ke) and cost of retained earnings (Kr). Later you weight them to get WACC.

Debt is the only source where tax helps you. Interest is deductible, so the real cost to the company is lower: Kd after tax = Kd × (1 − t). Dividends on preference and equity shares are paid out of post-tax profit, so there is no tax adjustment for them.

Equity has no fixed payout, so its cost is estimated. Two common routes are the dividend growth model (based on the expected dividend and its growth) and CAPM (based on risk-free return, beta and market return). Retained earnings are not free. Shareholders could have received that profit as dividends and reinvested it themselves, so Kr is treated as equal to Ke, usually without issue-cost adjustment.

For redeemable securities, you use a yield-type approximation: average annual payment plus the yearly gain or loss on redemption, divided by the average of net proceeds and redemption value.

Key rules to remember

Cost of irredeemable debt (before tax): Kd = I ÷ NP; I = annual interest; NP = net proceeds (issue price less issue costs).
Cost of irredeemable debt (after tax): Kd after tax = [I ÷ NP] × (1 − t); t = tax rate. Use only if the company pays tax and the question gives a rate.
Cost of redeemable debt (approximation): Kd = [I + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]; RV = redemption value; n = years to maturity. Multiply by (1 − t) for after-tax cost. Use NP, not face value, in the (RV − NP) term.
Cost of irredeemable preference shares: Kp = PD ÷ NP; PD = annual preference dividend. No tax adjustment.
Cost of redeemable preference shares (approximation): Kp = [PD + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]; Same structure as redeemable debt, without tax.
Cost of equity: dividend growth model: Ke = (D1 ÷ P0) + g; D1 = expected dividend next year = D0 × (1 + g). P0 = current market price; use net proceeds for new issue.
Cost of equity: CAPM: Ke = Rf + β × (Rm − Rf); Rf = risk-free rate; Rm = market return; (Rm − Rf) = market risk premium.
Cost of equity: earnings model: Ke = E1 ÷ P0; Use when earnings do not grow; E1 = expected EPS.
Cost of retained earnings: Kr = Ke; Where the question asks for a tax or brokerage adjustment on shareholders' reinvestment, follow the data given.
Growth rate from retention: g = b × r; b = retention ratio; r = return on equity or on retained funds.

How to solve Cost of Capital Components questions

Use this sequence for any cost of capital component question.

1List each source and the data given: face value, issue price, issue cost, coupon or dividend rate, redemption terms, tax rate.
2Find the cash received: net proceeds = issue price less flotation cost (or discount). Use this for new issues. For existing securities, use market price.
3Compute the annual payment: interest = coupon rate × face value; dividend = rate × face value.
4Choose the formula: irredeemable or redeemable; for equity, dividend growth, CAPM or earnings model, based on the data supplied.
5For redeemable items, find RV, NP and n, then apply the average-based formula.
6Apply the tax adjustment only to debt: multiply by (1 − t).
7Write each cost as a percentage, rounded sensibly (usually two decimals).
8State the result clearly, and if WACC follows, carry each cost forward with its weight.

Quickest way: Fast path for MCQs and step marks

When to use it: Use when you have about 3 to 4 minutes per question, or when the 1-2 mark MCQ gives just the data.

Underline the word irredeemable or redeemable first. It decides the formula.
Check whether the question says 'net of tax' or gives a tax rate. If so, adjust debt only.
Check which price to use: issue price less cost for new issues, market price for existing.
For equity, look at the data: dividend and growth means dividend model; beta means CAPM.
Eliminate options that have debt cost higher than the pre-tax rate, or preference cost reduced by tax. Those are wrong.
In written answers, show the formula, the substitution and the answer in separate lines. Step marks go to the formula and the net proceeds.

Common mistakes in Cost of Capital Components

Using face value instead of net proceeds in the denominator.
Students see the rate on face value and divide by the same figure without checking the issue price or costs.
Fix: Always compute net proceeds first. Interest is on face value; the denominator is cash actually received.
Applying the tax shield to preference or equity.
Students remember '(1 − t)' as a general rule for cost of capital.
Fix: Only interest is tax-deductible. Preference and equity dividends are paid after tax, so no adjustment.
Using D0 instead of D1 in the dividend growth model.
The question gives the dividend just paid, and students plug it in directly.
Fix: If the dividend is 'just paid' or 'last year', compute D1 = D0 × (1 + g). If it is 'expected', use it as D1.
Forgetting the redemption gain or loss in redeemable securities.
Students treat the security like an irredeemable one.
Fix: Add (RV − NP) ÷ n to the annual payment and divide by the average of RV and NP.
Treating retained earnings as costless.
No interest or dividend is paid on them directly, so they look free.
Fix: Remember the opportunity cost: shareholders could have earned Ke elsewhere. Use Kr = Ke.
Mixing percent and decimal in CAPM.
Beta is a plain number, and rates are percentages, so calculations drift.
Fix: Write all rates as percentages and multiply beta by the premium, such as 1.2 × 6% = 7.2%.

Worked examples

Example 1

A company issues 10% debentures of face value ₹100 each at a discount of 5%, with issue costs of ₹2 per debenture. They are redeemable at par after 5 years. The tax rate is 25%. Compute the after-tax cost of debt using the approximation formula.

Show the solution

Issue price = ₹100 − ₹5 = ₹95.
Net proceeds NP = ₹95 − ₹2 = ₹93.
Annual interest I = 10% × ₹100 = ₹10.
Redemption value RV = ₹100; n = 5.
Annual gain on redemption = (100 − 93) ÷ 5 = ₹1.40.
Average investment = (100 + 93) ÷ 2 = ₹96.50.
Pre-tax Kd = (10 + 1.40) ÷ 96.50 = 11.40 ÷ 96.50 = 11.81% (approx.).
After-tax Kd = 11.81% × (1 − 0.25) = 8.86% (approx.).

Answer: After-tax cost of debt is about 8.86%.

Example 2

The current market price of an equity share is ₹150. The company has just paid a dividend of ₹10 per share, expected to grow at 5% a year. Separately, the risk-free rate is 7%, the market return is 13% and the company's beta is 1.2. Compute (a) cost of equity by the dividend growth model, and (b) cost of equity by CAPM.

Show the solution

(a) D0 = ₹10, so D1 = 10 × 1.05 = ₹10.50.
D1 ÷ P0 = 10.50 ÷ 150 = 7%.
Ke = 7% + 5% = 12%.
(b) Market risk premium = 13% − 7% = 6%.
β × premium = 1.2 × 6% = 7.2%.
Ke = 7% + 7.2% = 14.2%.

Answer: (a) Ke by dividend growth model = 12%. (b) Ke by CAPM = 14.2%.

Exam tips

Read each question for the words 'redeemable', 'net of tax' and 'just paid' before choosing a formula.
In written answers, show net proceeds as a separate working line. It usually carries a step mark.
If a question gives both dividend data and beta, compute what is asked. If unspecified, state your assumption and show the model used.
For MCQs, test the answer for reasonableness: after-tax Kd must be lower than pre-tax Kd, and Ke should exceed Kd.
Keep two decimals in intermediate steps. Rounding too early can push you off the option.

Practice questions from Financing Decisions - Capital Structure

Cost of Capital Components 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 Components: frequently asked questions

Why is cost of debt adjusted for tax but not cost of equity?

Interest is an allowed expense, so it lowers taxable profit and the company saves tax. Dividends are paid from profit after tax, so there is no saving. That is why only debt cost is multiplied by (1 − t).

Which is better for cost of equity: dividend growth model or CAPM?

Neither is always better. The dividend growth model needs a stable growth estimate. CAPM needs beta and market data. In exams, use the model for which data is given, and mention the other only if asked.

Is the cost of retained earnings the same as the cost of equity?

In most exam problems, yes. Retained profits belong to equity holders, so they expect the same return as on fresh equity. Flotation costs do not apply because no new shares are issued.

How do I find cost of redeemable preference shares?

Use the average-based approximation. Add the annual dividend to the yearly redemption gain or loss, then divide by the average of net proceeds and redemption value. Do not apply any tax adjustment.