Basic FinanceUnit 712 min read

Cost of Capital & WACC: Debt, Equity, and Capital Structure

Unit 7 of Basic Finance explains how companies calculate the cost of debt, equity, and preferred stock, then combine them into the Weighted Average Cost of Capital (WACC)—the minimum return a project must earn to create value. Covers formulas, real-world applications (e.g., Ncell’s financing, Daraz’s expansion), and ho

Padhai · Based on the official syllabus and past papers
Updated 30 Sept 2026

TAKEAWAYS:

The cost of capital is the return investors demand for funding a company’s projects, broken into debt, equity, and preferred stock costs.
WACC blends these costs using their market-value weights to measure a company’s overall cost of raising capital.
Debt cost is calculated after-tax (since interest is tax-deductible), while equity cost (using CAPM or dividend growth models) is not.
Capital structure decisions (debt vs. equity mix) directly impact WACC—optimal structure minimizes WACC and maximizes shareholder value.
Real-world use: Banks like NMB use WACC to evaluate loan projects; eSewa applies it to assess digital payment system expansions.
Exam focus: Memorize formulas (e.g., WACC = $w_{d} r_{d} (1 - T) + w_{e} r_{e}$ ), solve numerical problems, and explain trade-offs in financing choices.

1. Cost of Capital: The Building Blocks of WACC

The cost of capital is the minimum return a company must earn on its investments to satisfy all investors (debt holders, shareholders, and preferred stockholders). It acts as the hurdle rate for capital budgeting decisions.

A. Components of Cost of Capital

The three primary sources of capital and their costs are:

Source of Capital	Cost Formula	Key Notes
Debt (Bonds/Loans)	$r_{d} = \frac{Interest Expense}{Net Proceeds}$ (after-tax: $r_{d} (1 - T)$ )	Tax-deductible; lower cost than equity.
Equity (Common Stock)	CAPM: $r_{e} = r_{f} + β (r_{m} - r_{f})$ or Dividend Growth: $r_{e} = \frac{D _{1}}{P _{0}} + g$	No tax shield; higher risk = higher cost.
Preferred Stock	$r_{p} = \frac{Dividend}{Market Price}$	Hybrid of debt/equity; fixed dividend, no tax benefit.

(Shows how debt increases liabilities while equity increases shareholders’ equity.)

B. Why After-Tax Cost for Debt?

Interest payments on debt are tax-deductible, reducing the company’s taxable income. Thus, the after-tax cost of debt is: $r_{d}^{after-tax} = r_{d} \times (1 - T)$ where $T$ = corporate tax rate (e.g., 27% in Nepal for most businesses).

Example (Nepal Context): Suppose Ncell issues a 10-year bond with:

Face value (par): Rs 1,000
Coupon rate: 8% (Rs 80/year)
Market price: Rs 950
Tax rate: 27%

Step 1: Calculate pre-tax cost of debt ( $r_{d}$ ) $r_{d} = \frac{Annual Interest}{Market Price} = \frac{80}{950} = 8.42%$

Step 2: After-tax cost $r_{d}^{after-tax} = 8.42% \times (1 - 0.27) = 6.19%$

Why this matters: Ncell’s WACC will use 6.19% (not 8.42%) for the debt component because taxes reduce its true cost.

2. Weighted Average Cost of Capital (WACC)

WACC is the average cost of all capital sources, weighted by their proportion in the capital structure. It represents the minimum return a project must generate to add value.

A. WACC Formula

$WACC = (\frac{D}{V} \times r_{d} \times (1 - T)) + (\frac{E}{V} \times r_{e}) + (\frac{P}{V} \times r_{p})$ Where:

$D$ = Market value of debt
$E$ = Market value of equity
$P$ = Market value of preferred stock
$V = D + E + P$ = Total market value of capital
$r_{d}, r_{e}, r_{p}$ = Costs of debt, equity, and preferred stock

Mermaid Diagram: WACC Calculation Flow

Market value breakdown (D + E + P = ₹10,500,000)

B. Worked Example: Kathmandu Retail Shop’s WACC

Scenario: A small retail shop in Kathmandu wants to expand. Its capital structure and costs are:

Debt: Rs 5,000,000 (market value), 10% interest rate, tax rate = 27%
Equity: Rs 10,000,000 (market value), $r_{e} = 14%$ (from CAPM)
Preferred Stock: Rs 1,000,000, 8% dividend rate

Step 1: Calculate Individual Costs

After-tax cost of debt: $r_{d} = 10% \times (1 - 0.27) = 7.3%$
Cost of equity ( $r_{e}$ ): Given as 14% (from CAPM or dividend growth).
Cost of preferred stock: $r_{p} = \frac{8% \times Par Value}{Market Price} = 8% (assuming par = market price)$

Step 2: Calculate Weights $V = D + E + P = 5, 000, 000 + 10, 000, 000 + 1, 000, 000 = 16, 000, 000$ $w_{d} = \frac{5 , 000 , 000}{16 , 000 , 000} = 0.3125 (31.25%)$ $w_{e} = \frac{10 , 000 , 000}{16 , 000 , 000} = 0.625 (62.5%)$ $w_{p} = \frac{1 , 000 , 000}{16 , 000 , 000} = 0.0625 (6.25%)$

Step 3: Compute WACC $WACC = (0.3125 \times 7.3%) + (0.625 \times 14%) + (0.0625 \times 8%)$ $WACC = 2.28% + 8.75% + 0.5% = 11.53%$

Interpretation: The retail shop’s minimum acceptable return on any new project is 11.53%. Projects earning less than this will destroy shareholder value.

3. Real-World Applications of WACC

A. In Nepali Businesses

Ncell’s Network Expansion
- Idea Used: WACC to evaluate whether expanding 5G towers in Pokhara is viable.
- How: Ncell calculates WACC (e.g., 10%) and compares it to the expected IRR (12%) of the project. Since 12% > 10%, the expansion is approved.

Typical capital structure for a Nepali retail firm (₹10.5M)

eSewa’s Digital Payment System
- Idea Used: Cost of equity (CAPM) to determine the return demanded by investors for funding app development.
- How: eSewa’s $r_{e}$ (e.g., 16%) is used in WACC to decide whether to invest in blockchain-based transactions.
Daraz’s Inventory Management
- Idea Used: After-tax cost of debt to assess loan financing for warehouse expansion.
- How: Daraz’s WACC (e.g., 13%) helps decide whether to borrow Rs 500M at 9% (after-tax cost = 6.5%) or issue equity.

(Shows how listed companies use WACC to justify expansions.)

B. Global Examples

Google’s Capital Budgeting
- Uses WACC to prioritize projects like Google Fiber or AI research centers. Only projects exceeding WACC (e.g., 8%) get funding.
WhatsApp’s Acquisition by Facebook
- Facebook calculated WhatsApp’s WACC to determine the fair value of the acquisition (Rs 19.3B in 2014). The deal’s IRR had to exceed WACC.
Tesla’s EV Production Lines
- WACC helps Tesla decide whether to build new Gigafactories. For example, a project with a 15% IRR and 10% WACC is accepted.

4. Capital Structure and WACC: The Trade-Off

The debt-equity mix directly affects WACC. The relationship is captured by the Modigliani-Miller (MM) Theory with taxes:

$WACC = r_{0} - T \times \frac{D}{E}$ Where:

$r_{0}$ = Cost of capital with no debt (all-equity firm).
$T \times \frac{D}{E}$ = Tax shield benefit from debt.

Key Insights:

More debt → Lower WACC (due to tax shield) but higher risk (default risk increases $r_{e}$ ).
Optimal capital structure balances these trade-offs to minimize WACC.

Mermaid Diagram: WACC vs. Debt-Equity Ratio

Trade-off between tax shield and risk (Nepali SME example)

Example (Nepal Context): Suppose a hotel in Thamel has two financing options:

Option 1: 40% debt, 60% equity → WACC = 12%
Option 2: 70% debt, 30% equity → WACC = 11.5% (lower due to tax shield)

But: If debt rises to 90%, $r_{e}$ may jump to 20% (due to risk), making WACC = 13%. Thus, 70% debt is optimal.

5. Common Mistakes and Pitfalls

Mistake	Why It’s Wrong	Correct Approach
Using book value instead of market value for weights.	Book value ignores market perceptions (e.g., equity may be over/undervalued).	Always use market values for $D, E, P$ .
Ignoring taxes on debt cost.	Overstates the true cost of debt.	Use after-tax cost: $r_{d} (1 - T)$ .
Assuming constant capital structure.	Firms adjust debt/equity over time (e.g., after a project).	Use target capital structure for long-term WACC.
Misapplying CAPM for $r_{e}$ .	Wrong inputs (e.g., incorrect beta or risk-free rate).	Use Nepal’s risk-free rate (~7-8%) and local beta (e.g., 1.2 for banks).

6. Exam Tip: How to Score Full Marks

A. Formula Recall (30% of marks)

Memorize these 3 formulas:
1. After-tax cost of debt: $r_{d} (1 - T)$
2. CAPM for equity: $r_{e} = r_{f} + β (r_{m} - r_{f})$
3. WACC: $w_{d} r_{d} (1 - T) + w_{e} r_{e} + w_{p} r_{p}$
Example Question: "Calculate the after-tax cost of debt for a bond with 9% coupon, Rs 900 market price, Rs 1,000 par, and 27% tax." Answer: $r_{d} = \frac{90}{900} = 10%, r_{d}^{after-tax} = 10% \times (1 - 0.27) = 7.3%$

B. Numerical Problems (40% of marks)

Steps to solve WACC questions:
1. Identify capital sources (debt, equity, preferred).
2. Calculate individual costs (use given data or formulas).
3. Find market values (if not given, assume par = market for simplicity).
4. Compute weights ( $w_{d}, w_{e}, w_{p}$ ).
5. Plug into WACC formula.
Example Question: "A company has Rs 20M debt (12% cost), Rs 30M equity ( $r_{e} = 15%$ ), and Rs 10M preferred stock (9% cost). Tax rate = 27%. Calculate WACC." Answer: $r_{d}^{after-tax} = 12% \times 0.73 = 8.76%$ $V = 20 + 30 + 10 = 60 M$ $w_{d} = 20/60 = 0.333, w_{e} = 30/60 = 0.5, w_{p} = 10/60 = 0.167$ $WACC = (0.333 \times 8.76%) + (0.5 \times 15%) + (0.167 \times 9%) = 11.75%$

C. Conceptual Questions (30% of marks)

Key points to mention:
- WACC is the hurdle rate for NPV calculations.
- Optimal capital structure minimizes WACC.
- Debt is cheaper than equity (due to tax shield) but increases risk.
- Market values > book values for weights.
Example Question: "Why does WACC decrease with more debt, up to a point?" Answer:
- Tax shield benefit: Interest is tax-deductible, reducing WACC.
- But: Too much debt increases business risk, raising $r_{e}$ and offsetting the tax benefit.

7. Quick Revision Table

Concept	Formula	Example (Nepal)
After-tax cost of debt	$r_{d} (1 - T)$	NMB bank’s bond: $10% \times 0.73 = 7.3%$
CAPM (Cost of equity)	$r_{f} + β (r_{m} - r_{f})$	For a bank: $7% + 1.2 \times (12% - 7%) = 13.4%$
WACC	$w_{d} r_{d} (1 - T) + w_{e} r_{e}$	Kathmandu retail shop: 11.53% (from earlier example)
Optimal capital structure	Minimizes WACC	Ncell’s 60% equity, 40% debt balance

8. Final Checklist Before the Exam

Can you calculate after-tax cost of debt? (Yes: $r_{d} (1 - T)$ )
Do you know how to find $r_{e}$ using CAPM or dividend growth? (Yes: Both methods)
Can you compute WACC from given data? (Yes: Weights + individual costs)
Do you understand the debt-equity trade-off? (Yes: Tax shield vs. risk)
Can you explain why WACC is used in NPV? (Yes: It’s the discount rate for projects)

Good luck! 🚀 (Remember: WACC is your friend—it tells you whether a project is worth pursuing!)

Based on the TU BBA syllabus for Basic Finance (FIN211), unit 7.

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