NISM-Series-XV: Research Analyst · Valuation Principles

Cost of Equity and WACC for NISM Research Analyst

Updated 11 October 2026 · Fact-checked

Cost of equity is the return shareholders require, estimated with CAPM: Risk-free rate + Beta × (Market return − Risk-free rate). WACC is the average cost of all funding, weighted by market-value proportions, using after-tax cost of debt: E/V × Ke + D/V × Kd × (1 − tax rate).

Understand Cost of Equity and WACC

Every business is funded by shareholders and lenders. Both want a return for the risk they take. That required return is the cost of capital. A project or company is worth pursuing only if it earns more than this cost.

Cost of equity (Ke) is the return shareholders expect for holding the stock. Unlike interest, it is not a fixed contract. So analysts estimate it. The most common method is the Capital Asset Pricing Model (CAPM). It says the required return equals the risk-free return plus a premium for market risk. The premium depends on beta, which measures how much the stock moves with the market.

Cost of debt (Kd) is the interest rate the company pays on its borrowings. Interest is tax-deductible, so the real cost to the company is lower. This is the after-tax cost of debt: Kd × (1 − tax rate). Debt is cheaper than equity because lenders have a prior claim and carry less risk.

WACC combines the two. You weight each cost by its share of total capital. Use market values where available. WACC is the discount rate for free cash flow to the firm (FCFF). Cost of equity is the discount rate for free cash flow to equity (FCFE) and dividend models.

Key formulas to remember

CAPM (cost of equity): Ke = Rf + β × (Rm − Rf); Rf is the risk-free rate, Rm the expected market return. (Rm − Rf) is the market risk premium.
After-tax cost of debt: Kd (after tax) = Kd × (1 − T); T is the tax rate. Use the interest rate on the debt, not the coupon of an old issue if market yield differs.
WACC: WACC = (E ÷ V) × Ke + (D ÷ V) × Kd × (1 − T); E = market value of equity, D = market value of debt, V = E + D.
Capital weights: E ÷ V and D ÷ V, where V = E + D; The weights must add up to 1 (or 100%).

How to solve Cost of Equity and WACC questions

Use this order for any question on cost of equity or WACC. Keep all rates in the same form, either percentages or decimals.

1Identify what is asked: Ke, after-tax Kd, weights or WACC.
2For Ke, note Rf, beta and either Rm or the market risk premium. If Rm is given, compute Rm − Rf first.
3Compute Ke = Rf + β × premium.
4Compute after-tax Kd = Kd × (1 − T).
5Find weights. Use market values. If given as a ratio such as debt-equity 1:3, convert to D/V = 1/4 and E/V = 3/4.
6Multiply each cost by its weight and add them to get WACC.
7Check that the answer lies between after-tax Kd and Ke. Then match with the options.

Quickest way: Range check and weight shortcut

When to use it: Use when options are close and time is short.

WACC must be above after-tax Kd and below Ke. Cross out options outside this range.
Convert the debt-equity ratio straight into fractions of V.
Do Ke first, then the after-tax Kd. Then do the two products and add.
If the question gives the market risk premium directly, do not subtract Rf again.

Common mistakes in Cost of Equity and WACC

Using Rm instead of (Rm − Rf) in the beta term.
Students remember 'beta × market return'.
Fix: Write Rf + β × (Rm − Rf). Beta multiplies only the premium.
Using pre-tax cost of debt in WACC.
The tax shield is forgotten.
Fix: Always multiply Kd by (1 − T) unless the question says the rate is already after tax.
Treating a debt-equity ratio as the debt weight.
A ratio of 1:2 looks like 1/2 debt.
Fix: Debt weight is D ÷ (D + E). For D/E = 1/2, D/V = 1/3.
Using book values when market values are given.
Balance sheet figures look familiar.
Fix: Use market values for weights whenever the question provides them.
Saying equity is cheaper than debt.
Confusion over who bears more risk.
Fix: Equity holders are paid last and bear more risk, so Ke is normally higher than Kd.
Mixing percentages and decimals.
Rushing arithmetic.
Fix: Convert 8% to 0.08 before multiplying, or keep everything in percent.

Worked examples

Example 1

The risk-free rate is 7%, the expected market return is 13% and a stock's beta is 1.2. What is the cost of equity under CAPM?

Show the solution

Market risk premium = 13% − 7% = 6%.
Beta × premium = 1.2 × 6% = 7.2%.
Ke = 7% + 7.2% = 14.2%.

Answer: 14.2%

Example 2

A company has equity of ₹60 crore and debt of ₹40 crore, both at market value. Cost of equity is 14%, pre-tax cost of debt is 10% and the tax rate is 25%. Find the WACC.

Show the solution

V = 60 + 40 = ₹100 crore. E/V = 0.6 and D/V = 0.4.
After-tax Kd = 10% × (1 − 0.25) = 7.5%.
Equity part = 0.6 × 14% = 8.4%.
Debt part = 0.4 × 7.5% = 3.0%.
WACC = 8.4% + 3.0% = 11.4%.

Answer: 11.4%

Exam tips

Questions usually give numbers and ask for one step, such as Ke or after-tax Kd. Do not compute more than needed.
Watch for 'after-tax' and 'pre-tax' wording in options. The trap is the pre-tax answer.
Remember which rate goes with which cash flow: WACC with FCFF, Ke with FCFE and dividends.
Expect conceptual statements, such as debt being cheaper than equity because of lower risk and the interest tax shield.
With negative marking, skip only if you cannot narrow to two options. The range check often does that.

Practice questions from Valuation Principles

Cost of Equity and WACC 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 Equity and WACC: frequently asked questions

How do I calculate cost of equity using CAPM?

Use Ke = Rf + β × (Rm − Rf). Subtract the risk-free rate from the market return, multiply by beta, then add the risk-free rate.

What is the difference between cost of equity and cost of debt?

Cost of equity is the return shareholders require and is estimated, for example with CAPM. Cost of debt is the interest the company pays on borrowings, and it is reduced by the tax shield. Equity is riskier, so its cost is usually higher.

Why is cost of debt taken after tax in WACC?

Interest is a deductible expense, so it lowers the tax the company pays. The effective cost to the company is Kd × (1 − T).

Which weights should I use in WACC?

Use market values of equity and debt as proportions of total capital. Use the values given in the question.