Corporate Accounting and Financial Management · Operational Approach to Financial Decision

Cost of Capital: Formulas and Calculation Methods

Updated 11 October 2026 · Fact-checked

Cost of capital is the minimum return a firm must earn on an investment to keep its investors satisfied. To solve a question, find the cost of each source: debt (after tax), preference shares, equity (dividend growth or CAPM) and retained earnings. Use market or net-proceeds values as the question directs.

Understand Cost of Capital

Every rupee a company raises has a price. Lenders want interest. Preference shareholders want a fixed dividend. Equity shareholders want dividends and growth. Cost of capital is this price, expressed as an annual percentage rate.

For the company, it works as a hurdle rate. A project that earns less than the cost of the funds used to finance it reduces shareholder wealth. That is why cost of capital is used to accept or reject projects and to compare financing choices.

Costs are of two kinds. Explicit cost is the discount rate that equates the present value of cash inflows from the source with the present value of its cash outflows. Debt and preference capital have clear explicit costs. Implicit cost is the return lost by not using funds elsewhere, an opportunity cost. Retained earnings are the usual example: no cash is paid out, but shareholders could have earned a return if the profit had been distributed.

Debt is special because interest is tax-deductible. So you always compute cost of debt after tax. Dividends are paid out of post-tax profit, so preference and equity costs are not adjusted for tax.

Equity is the hardest because its return is not fixed. You estimate it from the dividend growth model or from CAPM. Retained earnings are normally taken at the same cost as equity, unless the question mentions personal tax or brokerage adjustments.

Key rules to remember

Cost of irredeemable debt (before tax): Kd = I ÷ NP; I = annual interest; NP = net proceeds (face value adjusted for premium, discount and issue cost). Use market price if the question asks for it.
Cost of irredeemable debt (after tax): Kd (after tax) = Kd × (1 − t); t = tax rate. Equivalent form: I × (1 − t) ÷ NP.
Cost of redeemable debt (approximate): Kd = [I + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]; RV = redemption value; n = years to maturity. Multiply by (1 − t) for after-tax cost. Use YTM/IRR if exact value is asked.
Cost of irredeemable preference shares: Kp = PD ÷ NP; PD = annual preference dividend. No tax adjustment. Dividend distribution tax is not considered unless the question states it.
Cost of redeemable preference shares (approximate): Kp = [PD + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]; Same logic as redeemable debt, without tax.
Cost of equity: dividend yield method: Ke = D1 ÷ P0; Use only when dividends are expected to stay constant.
Cost of equity: dividend growth (Gordon) model: Ke = D1 ÷ P0 + g, where D1 = D0 × (1 + g); D1 is next year's dividend. Use net proceeds if floatation costs are given. g is the constant growth rate.
Cost of equity: earnings yield method: Ke = E1 ÷ P0; E1 = expected EPS; works when all earnings are assumed paid out or the question asks for it.
Cost of equity: CAPM: Ke = Rf + β × (Rm − Rf); Rf = risk-free rate; Rm = expected market return; (Rm − Rf) = market risk premium.
Cost of retained earnings: Kr = Ke (simple case); With personal tax and brokerage: Kr = Ke × (1 − personal tax rate) × (1 − brokerage cost), only if the question gives these.

How to solve Cost of Capital questions

Use this sequence for any cost of capital question, whatever the source of funds.

1Identify the source: debt, preference, equity or retained earnings. Check whether it is irredeemable or redeemable.
2List the data given: face value, issue price, premium or discount, issue cost, coupon or dividend rate, market price, growth rate, tax rate.
3Compute net proceeds: issue price less discount and floatation cost. Use market price instead if the question asks for cost on current market value.
4Choose the formula that fits the data. For equity: growth data means dividend growth model; beta and market return mean CAPM.
5Convert the rate or amount correctly. Interest and dividend are on face value; the denominator is net proceeds or market price.
6Apply the tax adjustment to debt only: multiply by (1 − t).
7Express the answer as a percentage, rounded as the question says, and state the basis used.
8If a WACC is also asked, weigh each cost by its proportion of capital after finishing every individual cost.

Quickest way: Three-line cost table

When to use it: Use when a question gives several sources of capital and you must find each cost under time pressure.

Draw a three-column table: source, annual payout per security, net amount received per security.
Divide payout by net amount for each row. For debt, payout is I × (1 − t); for equity, payout is D1.
Add g to the equity row only. For CAPM questions, skip the table and plug values straight into Rf + β × (Rm − Rf).
Check that debt is lowest, then preference, then equity. If not, recheck the data.

Common mistakes in Cost of Capital

Forgetting the tax shield on debt
Students apply the debt formula and stop at Kd.
Fix: Whenever a tax rate is given, multiply by (1 − t). Do not apply tax to preference or equity.
Using D0 instead of D1 in the growth model
The last paid dividend is the figure that stands out in the question.
Fix: Compute D1 = D0 × (1 + g) unless the question states the expected dividend directly.
Dividing interest by face value when issue cost or discount exists
Coupon is a percentage of face value, so students use face value as the base.
Fix: Interest comes from face value; the denominator must be net proceeds.
Treating retained earnings as free
No cash outflow is visible, so students assume zero cost.
Fix: Retained earnings carry an implicit cost equal to the cost of equity, unless adjusted by the data given.
Mixing percentages and decimals in CAPM
Beta is a number but returns are percentages.
Fix: Write all rates in the same form. Market premium is (Rm − Rf), not Rm alone.
Applying floatation cost to retained earnings
Students copy the equity share calculation.
Fix: Retained earnings involve no issue cost. Use current market price without floatation adjustment.

Worked examples

Example 1

A company issues 12% irredeemable debentures of ₹100 each at a discount of 5%, with floatation cost of ₹2 per debenture. The tax rate is 25%. Find the after-tax cost of debt.

Show the solution

Interest per debenture = 12% × ₹100 = ₹12.
Issue price = ₹100 − ₹5 = ₹95.
Net proceeds = ₹95 − ₹2 = ₹93.
Before-tax cost = 12 ÷ 93 = 12.90% approximately.
After-tax cost = 12.90% × (1 − 0.25) = 9.68% approximately.

Answer: After-tax cost of debt is about 9.68%.

Example 2

The equity share of Sundaram Ltd is quoted at ₹150. It has just paid a dividend of ₹10 per share, expected to grow at 6% a year. The risk-free rate is 7%, market return is 13% and the beta is 1.2. Find the cost of equity by (a) the dividend growth model and (b) CAPM.

Show the solution

(a) D1 = 10 × 1.06 = ₹10.60.
Ke = 10.60 ÷ 150 + 0.06 = 0.0707 + 0.06 = 13.07% approximately.
(b) Market risk premium = 13% − 7% = 6%.
Ke = 7% + 1.2 × 6% = 7% + 7.2% = 14.2%.
The two methods use different assumptions, so the answers differ.

Answer: Cost of equity is about 13.07% by the dividend growth model and 14.2% by CAPM.

Exam tips

Read whether the question wants cost on face value, net proceeds or market price, and write your basis in the answer.
Show the formula first, then substitution. Marks are awarded for the method even if arithmetic slips.
If both growth data and CAPM data are given, answer by the method the question names; if none, state your choice and why.
Keep percentages to two decimals during working and round only at the end.
Be ready for short notes on explicit versus implicit cost: explicit is a real cash cost like interest; implicit is an opportunity cost like retained earnings.

Practice questions from Operational Approach to Financial Decision

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

What is the difference between explicit and implicit cost of capital?

Explicit cost is the discount rate that equates the cash received from a source with the cash paid out on it, as with debt interest. Implicit cost is the opportunity cost of funds retained and used in the business, such as retained earnings. No cash leaves the firm for implicit cost, but the return is still forgone.

Why is cost of debt taken after tax?

Interest is deductible while computing taxable profit, so the real burden on the company is lower than the interest paid. The adjustment is Kd × (1 − t). Dividends are not deductible, so equity and preference costs are not adjusted.

When do I use CAPM instead of the dividend growth model?

Use CAPM when the question gives beta, a risk-free rate and a market return. Use the dividend growth model when it gives dividends, growth and share price. If the question names a method, follow it.

Is the cost of retained earnings equal to the cost of equity?

In the basic treatment, yes, because shareholders expect the same return on funds kept in the business as on new equity. Adjustments arise only if the question gives personal tax or brokerage, and there is no floatation cost on retained earnings.