Corporate Accounting and Financial Management · Capital Structure

Sources of Long-Term Capital and Cost of Capital

Updated 11 October 2026 · Fact-checked

Cost of capital is the minimum return a company must earn on its investments to satisfy its capital providers. You calculate the cost of each source (debt, preference, equity, retained earnings), then weight each by its share in the capital structure to get the weighted average cost of capital (WACC).

Understand Sources of Long-Term Capital and Cost of Capital

A company raises long-term money from four main sources: equity share capital, preference share capital, debt (debentures and term loans) and retained earnings. Each provider expects a return. That expected return is the cost of that source to the company.

Debt is usually the cheapest because lenders are paid first, face less risk, and interest is tax-deductible. Preference shares come next: the dividend is fixed but is not tax-deductible. Equity is the costliest because shareholders bear the most risk and are paid last.

Retained earnings are not free. If profits are kept back, shareholders lose the chance to earn that return elsewhere. So the cost of retained earnings is treated as equal to the cost of equity (ignoring issue costs and taxes on the shareholder's side, as most textbook problems do).

The overall cost is WACC. You multiply each source's cost by its weight and add them up. Weights can be book values or market values. If the question does not say, use the values given. Market value weights are theoretically better; book value weights are simpler.

WACC is used as the discount rate in capital budgeting. A project that earns more than WACC adds value. One that earns less destroys value.

Key rules to remember

Cost of debt (irredeemable), after tax: Kd = [I ÷ NP] × (1 − t); I = annual interest, NP = net proceeds (issue price less floatation cost), t = tax rate. If debt is issued at par with no cost, Kd = interest rate × (1 − t).
Cost of debt (redeemable), approximate: Kd = [I + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2] × (1 − t); RV = redemption value, n = years to maturity. Apply (1 − t) to the whole result, as shown here, only if the interest-based method treats the premium and discount as tax-deductible; follow the question's convention.
Cost of preference shares (irredeemable): Kp = PD ÷ NP; PD = annual preference dividend. No tax adjustment, because dividend is paid out of after-tax profit.
Cost of preference shares (redeemable), approximate: Kp = [PD + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]; Same logic as redeemable debt but without tax.
Cost of equity: dividend growth model: Ke = (D1 ÷ P0) + g; D1 = expected dividend next year = D0 × (1 + g). P0 = current market price (or net proceeds for new issue). g = constant growth rate.
Cost of equity: CAPM: Ke = Rf + β × (Rm − Rf); Rf = risk-free rate, Rm = expected market return, (Rm − Rf) = market risk premium, β = beta.
Cost of equity: earnings yield: Ke = E1 ÷ P0; Used when the question gives EPS and price and assumes no growth.
Cost of retained earnings: Kr = Ke; Use the same formula as equity, with P0 as market price and no floatation cost.
WACC: WACC = Σ (Weight × Cost) = (E×Ke + P×Kp + D×Kd + R×Kr) ÷ Total capital; Use the same weighting basis (book or market) for all sources. Weights add up to 1.

How to solve Sources of Long-Term Capital and Cost of Capital questions

Use this method for any cost of capital question, from a single-source cost to a full WACC.

1List every source of capital given: equity, preference, debentures, loans, reserves. Note the amount of each.
2Note the tax rate, floatation costs, discount or premium on issue, and redemption terms for each source.
3Compute net proceeds (NP) for each source: issue price less floatation cost, adjusted for discount or premium as stated.
4Calculate the cost of each source using the matching formula. Apply the tax adjustment to debt only.
5For equity, check what the question gives: dividend and growth (use dividend growth model), beta and market data (use CAPM), or EPS and price (earnings yield).
6Decide the weights. Use book or market values as the question specifies. Treat retained earnings as part of equity if asked, or as a separate source with cost equal to Ke.
7Multiply each cost by its weight, add the products, and divide by total capital if you used amounts instead of proportions.
8State the final WACC as a percentage and add one line on what it means, such as the minimum return needed from new projects.

Quickest way: Table method for WACC

When to use it: Use it whenever a question gives several sources with amounts and asks for WACC. It keeps working clean and earns step marks.

Draw four columns: Source, Amount (₹), Cost (%), Weighted cost (₹ or %).
Fill in the amounts first and total them.
Calculate each cost on the side and write only the final percentage in the table.
Multiply amount by cost to get the weighted cost in rupees. This avoids converting weights to decimals.
Add the weighted cost column and divide by total capital. This gives WACC.

Common mistakes in Sources of Long-Term Capital and Cost of Capital

Applying the tax adjustment to preference dividend or equity.
Students remember that tax matters for cost of capital and apply (1 − t) everywhere.
Fix: Only interest on debt is tax-deductible. Preference dividend and equity dividend come from after-tax profit, so no adjustment.
Using the face value instead of net proceeds or market price in the denominator.
Students copy the face value given at the start of the question and ignore issue price, discount and floatation cost.
Fix: Compute NP first: issue price less floatation cost. For existing equity use current market price P0.
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 question gives the dividend just paid, compute D1 = D0 × (1 + g). Use the given dividend as D1 only if it says 'expected' dividend.
Treating retained earnings as free or leaving them out of WACC.
Retained earnings carry no explicit payment, so they look costless.
Fix: Include them with a cost equal to Ke. Retained earnings belong to equity shareholders and carry their required return.
Mixing book and market weights in one WACC calculation.
Some amounts are given at book value and others at market price, and students use whatever is listed.
Fix: Pick one basis for all sources, as the question directs. If market values are given for all, use them throughout.
Forgetting to subtract the risk-free rate from market return in CAPM.
Students read Rm as the premium and multiply beta by it directly.
Fix: Write Ke = Rf + β × (Rm − Rf). First compute (Rm − Rf), then multiply by β, then add Rf.

Worked examples

Example 1

A company has the following capital structure: 12% debentures ₹4,00,000; 10% preference shares ₹2,00,000; equity share capital and reserves ₹6,00,000. Debentures and preference shares were issued at par with no floatation cost. The equity share price is ₹100, the expected dividend next year is ₹8 per share, and dividends grow at 5% a year. The tax rate is 30%. Calculate the WACC using book value weights.

Show the solution

Total capital = ₹4,00,000 + ₹2,00,000 + ₹6,00,000 = ₹12,00,000.
Cost of debt: Kd = 12% × (1 − 0.30) = 8.4%.
Cost of preference: Kp = 10% (issued at par, no tax adjustment).
Cost of equity: Ke = (8 ÷ 100) + 0.05 = 0.08 + 0.05 = 13%.
Weighted cost of debt = ₹4,00,000 × 8.4% = ₹33,600.
Weighted cost of preference = ₹2,00,000 × 10% = ₹20,000.
Weighted cost of equity = ₹6,00,000 × 13% = ₹78,000.
Total weighted cost = ₹33,600 + ₹20,000 + ₹78,000 = ₹1,31,600.
WACC = ₹1,31,600 ÷ ₹12,00,000 = 10.97% (approx.).

Answer: WACC is approximately 10.97%.

Example 2

Using CAPM, find the cost of equity for Sundaram Industries Ltd. The risk-free rate is 7%, the expected market return is 13% and the company's beta is 1.2. If the company's capital is 40% debt at a pre-tax cost of 10% and 60% equity, and the tax rate is 25%, find the WACC.

Show the solution

Market risk premium = Rm − Rf = 13% − 7% = 6%.
Ke = Rf + β × (Rm − Rf) = 7% + 1.2 × 6% = 7% + 7.2% = 14.2%.
After-tax cost of debt: Kd = 10% × (1 − 0.25) = 7.5%.
Weights: debt 0.40, equity 0.60.
WACC = (0.40 × 7.5%) + (0.60 × 14.2%) = 3.0% + 8.52% = 11.52%.

Answer: Cost of equity is 14.2% and WACC is 11.52%.

Exam tips

Write the formula before substituting numbers. Examiners award marks for the correct formula even if arithmetic slips.
Show the net proceeds calculation as a separate line whenever floatation cost, discount or premium is given.
Always state your assumption, such as 'book value weights used' or 'retained earnings cost taken equal to Ke', when the question is silent.
Present WACC in a neat table with amount, cost and weighted cost columns. It is easy to check and easy to score.
Practise questions that ask for a single cost, such as cost of redeemable debentures or CAPM equity cost, because they appear as short problems as well as parts of WACC.

Practice questions from Capital Structure

Sources of Long-Term Capital and 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.

Sources of Long-Term Capital and Cost of Capital: frequently asked questions

What is the formula for WACC in CS Executive?

WACC = Σ (weight of each source × its cost). In amounts, add up the rupee weighted costs and divide by total capital. Use the after-tax cost of debt and keep the same weighting basis for all sources.

Why is the cost of debt calculated after tax?

Interest on debt is a tax-deductible expense, so the company's real cost is lower than the interest rate. The after-tax cost is interest × (1 − tax rate). Preference and equity dividends are not deductible, so no adjustment applies.

When do I use CAPM and when the dividend growth model?

Use the dividend growth model when the question gives dividend, price and growth rate. Use CAPM when it gives beta, the risk-free rate and the market return. If both are given, calculate what the question asks for or show both.

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

In most exam problems, yes. Retained earnings belong to equity shareholders, so they expect the same return. Differences arise only if the question adds floatation costs for new equity or personal tax adjustments.

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

Use whichever the question specifies. Market value weights better reflect current investor expectations, while book values are simpler. Never mix the two in the same calculation.