Cost of Capital: Meaning, Components, WACC (Basic Computation and Interpretation) Questions

Question 1

Define cost of capital.

Accepted Answer

Cost of capital is the minimum **required return** a firm must earn on investments to satisfy providers of funds (concept).

Question 2

What is WACC?

Accepted Answer

WACC is **Weighted Average Cost of Capital**—the weighted average of costs of debt, equity and other sources (concept).

Question 3

Cost of capital is used as discount rate in NPV. (True/False)

Accepted Answer

True. Cost of capital is used as the **discount rate** (hurdle rate) in NPV (concept).

Question 4

State one component of cost of capital.

Accepted Answer

**Cost of debt (Kd)** (or cost of equity Ke, etc.).

Question 5

Cost of equity represents shareholders’ required return. (True/False)

Accepted Answer

True. **Cost of equity** is the return expected/required by equity shareholders (concept).

Question 6

Why is after-tax cost of debt considered? (one point) (concept)

Accepted Answer

Because interest is usually **tax-deductible**, the effective cost of debt is reduced after tax (concept).

Question 7

List components of cost of capital (any three) using a table.

Accepted Answer

Components (any three):

| Source | Component cost |
|---|---|
| **Debt** | Kd |
| **Equity** | Ke |
| Preference shares | Kp (concept) |
| Retained earnings | Kr (concept) |

Any three components are acceptable.

Question 8

Explain the meaning and use of cost of capital (any three points).

Accepted Answer

Meaning/use (any three):

- it is the **minimum required return** (hurdle rate)
- used as **discount rate** in NPV
- used to compare with IRR for acceptance (concept)
- helps in choosing debt–equity mix (concept)

Hence, it guides investment and financing decisions.

Question 9

Write WACC computation steps using a flowchart (brief).

Accepted Answer

WACC steps (flow):

Identify sources (D, E, P) → Find component costs (Kd, Ke, Kp) → Compute weights → Multiply weight × cost → Add to get **WACC** → Use as hurdle/discount rate

Question 10

Compute WACC: Debt 40% at 8%, Equity 60% at 12%. Interpret (brief).

Accepted Answer

WACC = (0.40 × 8%) + (0.60 × 12%) = 3.2% + 7.2% = **10.4%**.

Interpretation: 10.4% is the **hurdle rate**; projects should generally earn above this to add value (concept).

Question 11

Differentiate cost of debt and cost of equity (any three points) using a table.

Accepted Answer

Cost of debt vs cost of equity:

| Basis | **Cost of debt (Kd)** | **Cost of equity (Ke)** |
|---|---|---|
| Nature | contractual interest | required return expectation |
| Tax effect (concept) | often considered after-tax | no tax shield like interest |
| Risk | generally lower | generally higher (equity is residual) |

Thus, debt has fixed interest cost, while equity cost reflects shareholders’ required return.

Question 12

Explain what a hurdle rate is and how WACC is used as a hurdle rate (brief) with a small table.

Accepted Answer

**Hurdle rate** is the minimum acceptable return required for accepting a project.

| Item | Meaning |
|---|---|
| **WACC** | average required return of fund providers |
| Use | accept projects with return > **WACC** (concept) |

Thus, WACC often acts as the hurdle/discount rate in project evaluation.

Question 13

Write an exam-style answer on cost of capital: meaning, importance and components (include a table and conclusion).

Accepted Answer

### Meaning
**Cost of capital** is the minimum required return expected by providers of funds.

### Importance
- used as **discount rate** in NPV
- helps accept/reject projects (compare with IRR)
- supports financing decisions (debt–equity mix) (concept)

### Components (table)
| Source | Cost |
|---|---|
| **Debt** | Kd |
| **Equity** | Ke |
| Preference | Kp (concept) |

### Conclusion
Cost of capital acts as a hurdle rate for investment decisions and a guide for financing structure (concept).

Question 14

Write an exam-style answer on WACC: meaning, steps and interpretation (include a flow/table and conclusion).

Accepted Answer

### Meaning
**WACC** is the weighted average of component costs of debt, equity and other sources.

### Steps (flow)
Identify sources → Compute each component cost → Compute weights → Weighted average = **WACC**

| Symbol | Meaning |
|---|---|
| wd, we | weights of debt and equity |
| Kd, Ke | costs of debt and equity |

### Interpretation
WACC is the firm’s average **required return** and is used as the discount/hurdle rate (concept).

### Conclusion
Projects should generally earn returns above WACC to create value for investors (concept).

Question 15

Explain factors affecting cost of capital (exam-style) with a table and conclusion (any five points).

Accepted Answer

### Factors (any five) (concept)

| Factor | Effect on cost of capital |
|---|---|
| Business risk | higher risk → higher **required return** |
| Financial leverage | more debt risk → higher equity return expectation (concept) |
| Market interest rates | higher rates → higher debt cost |
| Creditworthiness | better rating → lower borrowing cost |
| Market expectations | investor return expectations change with conditions (concept) |

### Conclusion
Cost of capital depends on risk, leverage, and market conditions; firms try to reduce it through stronger stability and optimal financing (concept).

Source	Component cost
Debt	Kd
Equity	Ke
Preference shares	Kp (concept)
Retained earnings	Kr (concept)

Cost of Capital: Meaning, Components, WACC (Basic Computation and Interpretation)

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