Cost of capital is the required rate of return expected by providers of funds (equity holders, debt holders, preference shareholders). It is the minimum return a firm must earn on new investments to maintain its market value.
This topic is key because cost of capital is used as:
You should be able to:
Cost of capital is the rate of return that a firm must earn on its investments so that:
One-line exam definition: Cost of capital is the minimum required return on capital employed.
Common components:
Debt interest is tax deductible, so after-tax cost is lower:
If before-tax Kd = and tax rate = : Example line: If i = 10% and t = 30%, Kd(after) = 10%(1−0.30) = 7%.
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Financial Management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise.
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Cost of capital is the required rate of return expected by providers of funds (equity holders, debt holders, preference shareholders). It is the minimum return a firm must earn on new investments to maintain its market value.
This topic is key because cost of capital is used as:
You should be able to:
Cost of capital is the rate of return that a firm must earn on its investments so that:
One-line exam definition: Cost of capital is the minimum required return on capital employed.
Common components:
Debt interest is tax deductible, so after-tax cost is lower:
If before-tax Kd = and tax rate = : Example line: If i = 10% and t = 30%, Kd(after) = 10%(1−0.30) = 7%.
For irredeemable preference shares (basic approximation): If redeemable, a more detailed formula exists (not always required in basics).
Simple earnings yield approximation (basic theory): Dividend growth (Gordon) concept (if asked): (Keep conceptual unless numbers are provided.)
CAPM links expected return to systematic risk (beta): Where:
Interpretation:
WACC is the weighted average of costs of each capital component.
Working format:
In exams, use the weight basis specified; otherwise state assumption.
MCC is the cost of raising one additional rupee of new capital. It may increase when:
MCC is used to decide the cut-off point under capital rationing and for incremental financing decisions.
Flow: Identify sources → compute Kd/Kp/Ke → decide weights → compute WACC → use as discount rate
Quick concept table:
From this topic
Kd(after) = i(1 − t)
= 12%(1 − 0.30) = 12% × 0.70 = 8.4%.
CAPM:
Ke = Rf + β(Rm − Rf)
Where:
Thus, higher β increases required return on equity.
Cost of capital includes the required returns on different funding sources.
A firm’s overall cost of capital depends on the mix of these components.