Cost of Capital: Components, WACC, CAPM Concept and Marginal Cost (Overview) Questions

Question 1

Define cost of capital.

Accepted Answer

Cost of capital is the **minimum required return** that a firm must earn to satisfy providers of funds and maintain firm value.

Question 2

State one use of cost of capital.

Accepted Answer

It is used as the **discount rate** in NPV (capital budgeting) decisions.

Question 3

What is WACC?

Accepted Answer

WACC is the **weighted average** of the costs of different sources of capital (debt, equity, preference).

Question 4

Write the after-tax cost of debt formula.

Accepted Answer

After-tax cost of debt: **Kd(after) = i(1 − t)**.

Question 5

What does beta (β) represent in CAPM?

Accepted Answer

Beta (β) represents **systematic (market) risk**—the sensitivity of a stock’s return to market movements.

Question 6

Cost of debt is reduced by tax shield.

Accepted Answer

True. Interest is tax deductible, so effective **after-tax** cost of debt is lower.

Question 7

Compute after-tax cost of debt: interest rate 12% and tax rate 30%.

Accepted Answer

Kd(after) = **i(1 − t)**

= 12%(1 − 0.30) = 12% × 0.70 = **8.4%**.

| i | t | **Kd(after)** |
|---:|---:|---:|
| 12% | 30% | **8.4%** |

Question 8

Write the CAPM equation for cost of equity and explain each term briefly.

Accepted Answer

CAPM:

**Ke = Rf + β(Rm − Rf)**

Where:
- **Rf** = risk-free rate
- **Rm − Rf** = market risk premium
- **β** = systematic risk measure

Thus, higher β increases required return on equity.

Question 9

Compute cost of equity using CAPM: Rf=6%, β=1.2, Rm=14%.

Accepted Answer

Ke = **Rf + β(Rm − Rf)**

Rm − Rf = 14% − 6% = 8%
Ke = 6% + 1.2 × 8% = 6% + 9.6% = **15.6%**.

| Rf | β | Rm | **Ke** |
|---:|---:|---:|---:|
| 6% | 1.2 | 14% | **15.6%** |

Question 10

Compute WACC using weights: Debt 40% (Kd after tax 8%), Equity 60% (Ke 15%).

Accepted Answer

WACC = **w_d Kd + w_e Ke**

= 0.40×8% + 0.60×15%
= 3.2% + 9.0% = **12.2%**.

| Source | Weight | Cost | Weighted cost |
|---|---:|---:|---:|
| Debt | 0.40 | 8% | 3.2% |
| Equity | 0.60 | 15% | 9.0% |
| **WACC** | 1.00 |  | **12.2%** |

Question 11

Compute cost of preference shares (Kp): annual preference dividend ₹12, net proceeds ₹100 (ignore flotation).

Accepted Answer

Kp = **Dividend / Net proceeds**

= 12 / 100 = **0.12 = 12%**.

| Dividend | Net proceeds | **Kp** |
|---:|---:|---:|
| 12 | 100 | **12%** |

Question 12

Differentiate between book value weights and market value weights for WACC (any three points) using a table.

Accepted Answer

Book value vs market value weights:

| Basis | **Book value weights** | **Market value weights** |
|---|---|---|
| Source | balance sheet values | current market values |
| Relevance | easier to compute | more relevant for **valuation** |
| Stability | relatively stable | can fluctuate with market |

Use the basis specified in the question; otherwise state your assumption.

Question 13

Explain components of cost of capital (Kd, Kp, Ke, Kr) with a table (exam-style).

Accepted Answer

### Components
Cost of capital includes the required returns on different funding sources.

| Component | Meaning | Basic note |
|---|---|---|
| **Kd** | cost of debt | after-tax: **i(1−t)** |
| **Kp** | cost of preference shares | dividend / net proceeds (basic) |
| **Ke** | cost of equity | required return by equity holders |
| **Kr** | cost of retained earnings | opportunity cost, close to **Ke** |

### Conclusion
A firm’s overall cost of capital depends on the mix of these components.

Question 14

Explain WACC: meaning, steps and working format (exam-style) with a table and conclusion.

Accepted Answer

### Meaning
**WACC** is the weighted average of costs of all long-term funds (debt, equity, preference). It represents the firm’s overall hurdle rate.

### Steps
1) compute component costs (**Kd(after), Kp, Ke**)
2) decide weights (book/market)
3) compute weighted costs and sum

| Source | Value | Weight | Cost | Weighted cost |
|---|---:|---:|---:|---:|
| Debt | xxx | w_d | Kd | w_d×Kd |
| Equity | xxx | w_e | Ke | w_e×Ke |
| Pref | xxx | w_p | Kp | w_p×Kp |
| **WACC** |  | 1.00 |  | **Σ weighted** |

### Conclusion
Projects should generally earn returns ≥ **WACC** to maintain or increase firm value.

Question 15

Explain marginal cost of capital (MCC) and why it may differ from WACC (exam-style) with a small table/flow.

Accepted Answer

### Meaning
**MCC** is the cost of raising one additional rupee of new capital. It is relevant for evaluating **new** projects.

### Why MCC may differ from WACC
- cheaper sources (e.g., internal accruals) may get exhausted
- additional funds may require higher cost financing
- flotation costs can increase the effective cost

Flow: New funds needed → source changes → **cost changes** → MCC differs

| Concept | Focus |
|---|---|
| **WACC** | average cost of existing capital mix |
| **MCC** | incremental cost of new capital |

### Conclusion
Use MCC when assessing incremental financing; WACC gives a broad benchmark.

Cost of Capital: Components, WACC, CAPM Concept and Marginal Cost (Overview)

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