Financial Management and Business Data Analytics · Capital Structure and Capital Stacking

Cost of Capital and Capital Structure Planning

Updated 10 October 2026 · Fact-checked

Capital structure planning means choosing the debt-equity mix that gives the lowest weighted average cost of capital (WACC) and so the highest firm value. List each financing plan, convert debt cost to after-tax, weight each source by its proportion, compute WACC, and pick the lowest. Then test EPS and ROE for risk.

Understand Cost of Capital and Capital Structure Planning

Every rupee a firm raises has a cost. Debt is usually cheaper than equity, because lenders take less risk and interest is tax-deductible. Equity is costlier because shareholders bear more risk and expect a higher return.

The weighted average cost of capital (WACC) blends these costs using the share of each source in total capital. It is the minimum return the firm must earn on its investments to keep shareholders and lenders satisfied.

Capital structure planning links directly to WACC. When you add a little debt, WACC falls, because cheap after-tax debt replaces costly equity. But more debt raises financial risk, so lenders charge higher interest and shareholders demand a higher Ke. Beyond some point WACC starts rising. The mix at the lowest WACC is the optimal capital structure. At that point firm value is highest, because value moves opposite to WACC.

The syllabus gives you three practical approaches. The cost of capital approach compares WACC across plans and picks the minimum. The EBIT-EPS approach compares earnings per share under each plan at different EBIT levels and finds the indifference point. The ROI-ROE approach checks whether debt raises the return to shareholders: it does only when the return on investment is higher than the cost of debt.

A good plan also considers risk, control, flexibility and the ability to service debt. The lowest WACC or highest EPS alone is not the full answer, and your written conclusion should say so.

Key rules to remember

After-tax cost of debt: Kd (after tax) = Kd × (1 − t); Use this in WACC. Interest is tax-deductible; dividends are not.
WACC: WACC = Σ (Wi × Ki) = (E × Ke + P × Kp + D × Kd after tax) ÷ (E + P + D); Weights are proportions of total capital. Use market value weights when given; otherwise use the weights the question states.
Cost of equity (dividend growth): Ke = D1 ÷ P0 + g; D1 is next year's expected dividend, P0 is the current market price.
Cost of equity (CAPM): Ke = Rf + β × (Rm − Rf); Use when beta and market data are given.
EPS: EPS = [(EBIT − Interest) × (1 − t) − Preference dividend] ÷ Number of equity shares; Compute it for each financing plan at the same EBIT.
EBIT-EPS indifference point: (X − I1)(1 − t) ÷ N1 = (X − I2)(1 − t) ÷ N2, so X = (N2 × I1 − N1 × I2) ÷ (N2 − N1); X is EBIT. The shortcut holds when the tax rate is the same and there is no preference dividend. Above X the plan with more debt gives higher EPS; below X the equity-heavy plan does.
ROE with leverage: ROE = [ROI + (ROI − i) × D ÷ E] × (1 − t); i is the interest rate, ROI is pre-tax return on total capital. Debt raises ROE only when ROI > i.
Value of firm and WACC: Firm value = Market value of equity + Market value of debt; For a given EBIT, a lower WACC means a higher firm value.

How to solve Cost of Capital and Capital Structure Planning questions

Use this order for any question that asks for the best financing mix, whether it is based on WACC, EPS or ROE.

1Read the question and note the objective: minimum WACC, maximum EPS, or maximum ROE. Note the tax rate.
2List each plan with its debt, preference and equity amounts and their costs.
3Convert the cost of debt to after-tax: Kd × (1 − t). Find Ke from the given data if it is not stated.
4Work out the weight of each source as a proportion of total capital for each plan.
5Multiply each weight by its cost and add to get WACC. Present this in a table with one row per plan.
6For EPS questions, compute EPS under each plan at the given EBIT, and find the indifference point if asked.
7Pick the plan that meets the objective. State the number clearly.
8Add one line on risk, such as financial risk, interest coverage or control, and confirm that your choice is sound.

Quickest way: Table method for minimum WACC

When to use it: Use when the question gives two to four plans with different debt proportions and costs, and asks for the optimal one.

Make a table with columns: Source, Weight, Cost after tax, Weighted cost.
Convert Kd to after-tax once, at the top.
Compute weights as decimals (for example 0.4 and 0.6) so that you can multiply quickly.
Add weighted costs for each plan and circle the lowest WACC.
For two EPS plans, use X = (N2 × I1 − N1 × I2) ÷ (N2 − N1) to get the indifference EBIT in one line, then check by computing EPS at X. Both plans must give the same figure.

Common mistakes in Cost of Capital and Capital Structure Planning

Using pre-tax cost of debt in WACC
The interest rate is stated in the question and students plug it in directly.
Fix: Always write Kd × (1 − t) as the first line of your working. Do not tax-adjust Ke or Kp.
Choosing the plan with the highest EPS and stopping
EPS is easy to compute and looks decisive.
Fix: Higher EPS from debt comes with higher financial risk. Mention risk, and compare WACC or interest cover where data is given.
Dropping the number of shares or interest when setting the indifference equation
Students rush and mix up which plan has which N and I.
Fix: Write N1, I1 and N2, I2 for each plan before using the formula, and check by computing EPS at the answer under both plans.
Weights that do not add up to 1 or total capital
Amounts and percentages are mixed up, or retained earnings are left out.
Fix: Add the weights and confirm they equal 100% before multiplying.
Assuming debt always increases ROE
Students learn that leverage magnifies returns and forget the condition.
Fix: Compare ROI with the interest rate. If ROI is lower than the interest rate, debt reduces ROE.
Deducting preference dividend before tax in EPS
It is treated like interest.
Fix: Preference dividend is paid out of profit after tax. Deduct it after the tax step.

Worked examples

Example 1

Ananya Textiles needs total capital of ₹10,00,000. The tax rate is 25%. Three financing plans are considered. Plan A: 20% debt at 8% and 80% equity with Ke of 14%. Plan B: 40% debt at 9% and 60% equity with Ke of 15%. Plan C: 60% debt at 11% and 40% equity with Ke of 18%. Find the WACC of each plan and select the optimal plan.

Show the solution

After-tax Kd: Plan A = 8% × 0.75 = 6%. Plan B = 9% × 0.75 = 6.75%. Plan C = 11% × 0.75 = 8.25%.
Plan A WACC = 0.20 × 6 + 0.80 × 14 = 1.2 + 11.2 = 12.4%.
Plan B WACC = 0.40 × 6.75 + 0.60 × 15 = 2.7 + 9.0 = 11.7%.
Plan C WACC = 0.60 × 8.25 + 0.40 × 18 = 4.95 + 7.2 = 12.15%.
Compare: 12.4%, 11.7%, 12.15%. Plan B is lowest.
Comment: WACC first falls as cheap debt is added, then rises in Plan C because both Kd and Ke increase with financial risk.

Answer: WACC is 12.4% (A), 11.7% (B) and 12.15% (C). Plan B, with 40% debt and 60% equity, is the optimal structure because it has the minimum WACC and so the highest firm value.

Example 2

Mehta Pharma has 50,000 equity shares outstanding and no debt. It needs ₹10,00,000 for expansion. Option 1: issue 10,000 new equity shares at ₹100 each. Option 2: issue 10% debentures of ₹10,00,000. The tax rate is 25%. (a) Find the EBIT at which EPS is the same under both options. (b) Which option is better if expected EBIT is ₹9,00,000, and if it is ₹4,00,000?

Show the solution

Option 1: N1 = 50,000 + 10,000 = 60,000 shares, interest I1 = 0.
Option 2: N2 = 50,000 shares, interest I2 = 10% × 10,00,000 = ₹1,00,000.
Indifference: X ÷ 60,000 = (X − 1,00,000) ÷ 50,000 (the tax factor cancels).
50,000X = 60,000X − 6,00,00,00,000, so 10,000X = 6,00,00,00,000 and X = ₹6,00,000.
Check at ₹6,00,000: Option 1 EPS = 6,00,000 × 0.75 ÷ 60,000 = ₹7.50. Option 2 EPS = 5,00,000 × 0.75 ÷ 50,000 = ₹7.50. Equal.
At EBIT ₹9,00,000: Option 1 EPS = 6,75,000 ÷ 60,000 = ₹11.25. Option 2 EPS = 8,00,000 × 0.75 ÷ 50,000 = 6,00,000 ÷ 50,000 = ₹12.00.
At EBIT ₹4,00,000: Option 1 EPS = 3,00,000 ÷ 60,000 = ₹5.00. Option 2 EPS = 3,00,000 × 0.75 ÷ 50,000 = 2,25,000 ÷ 50,000 = ₹4.50.

Answer: The indifference EBIT is ₹6,00,000. At EBIT of ₹9,00,000, debentures give higher EPS (₹12.00 against ₹11.25). At ₹4,00,000, equity gives higher EPS (₹5.00 against ₹4.50). If EBIT is likely to stay above ₹6,00,000, debt is preferable, but the firm should also consider interest cover and the risk of a fall in EBIT.

Exam tips

In plan-selection questions, always show the WACC table. Even if one figure is wrong, step marks for the layout and the after-tax Kd are safe.
For MCQs on indifference point, use the shortcut formula and then confirm with one EPS calculation. There is no negative marking, so always attempt every MCQ.
State the decision rule in words: choose the minimum WACC, or choose debt only when EBIT is above the indifference point.
Close every written answer with one sentence on risk, control or flexibility. Examiners look for this judgement.
If the question gives market values of equity and debt, use them as weights instead of book values.

Practice questions from Capital Structure and Capital Stacking

Cost of Capital and Capital Structure Planning 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 Capital Structure Planning: frequently asked questions

How do I find the optimal capital structure with minimum WACC?

Compute WACC for each given debt-equity mix using after-tax cost of debt and the cost of equity for that mix. The mix with the lowest WACC is optimal. Firm value is highest at this point.

What is the difference between EBIT-EPS analysis and ROI-ROE analysis?

EBIT-EPS analysis compares earnings per share of different financing plans at various EBIT levels and finds the indifference point. ROI-ROE analysis shows how return on equity changes with debt, and debt helps only when ROI exceeds the interest rate.

Why does WACC first fall and then rise as debt increases?

At first, cheaper after-tax debt replaces costlier equity, so WACC falls. As debt grows, financial risk rises, so lenders charge more and shareholders demand a higher return, and WACC begins to rise.

Should I use book value or market value weights in WACC?

Use the weights the question gives. If both book and market values are provided, market values are more meaningful because they reflect the current value of each source. Do not mix the two in one calculation.