Business FinanceUnit 69 min read

Cost of Capital: Types, Calculation, and Business Decisions

Unit 6 of Business Finance explores how businesses determine the cost of raising funds (debt, equity, and hybrid sources), how to compute weighted average cost of capital (WACC), and how it guides investment and financing decisions—with real-world examples from Nepali tourism businesses and global finance.

Padhai · Based on the official syllabus and past papers
Updated 5 Oct 2026

Key Concepts and Definitions

1. What is Cost of Capital?

The cost of capital is the minimum return a company must earn on its investments to satisfy its investors (shareholders and lenders). It represents the opportunity cost of using funds for business operations or expansion.

For equity investors: It is the expected return they demand (e.g., dividends + capital gains).
For debt investors: It is the interest rate they require.
For the business: It is the blended cost of all financing sources, used to evaluate projects.

2. Components of Cost of Capital

The cost of capital is made up of:

Cost of Debt (k_d): Interest rate on loans/bonds.
Cost of Preferred Stock (k_p): Dividend yield on preferred shares.
Cost of Equity (k_e): Return expected by shareholders (dividend growth model or CAPM).
Cost of Retained Earnings (k_r): Opportunity cost of reinvesting profits instead of paying dividends.

Comparison Table: Cost of Capital Components

Component	Formula	Key Factors	Example (Nepal)
Cost of Debt (k_d)	$k_{d} = Interest Rate \times (1 - Tax Rate)$	Tax-deductible, lower risk for lenders	NMB Bank loan at 10% (after-tax cost = 8% if tax = 20%)
Cost of Preferred Stock (k_p)	$k_{p} = \frac{Dividend}{Market Price}$	Fixed dividend, no voting rights	Preferred shares of Nabil Bank at 12%
Cost of Equity (k_e)	Dividend Growth Model: $k_{e} = \frac{D _{1}}{P _{0}} + g$ <br> CAPM: $k_{e} = R_{f} + β (R_{m} - R_{f})$	Riskier than debt, no tax shield	Nepal Stock Exchange (NEPSE) shares with β = 1.2, $R_{f} = 8%$ , $R_{m} = 12%$ → $k_{e} = 13.6%$
Cost of Retained Earnings (k_r)	Same as $k_{e}$ (opportunity cost)	Reinvested profits, no new funds raised	Hotel Himalaya reinvests profits instead of paying dividends

3. Weighted Average Cost of Capital (WACC)

WACC is the average cost of all financing sources, weighted by their proportion in the capital structure.

Formula

$W A C C = (\frac{E}{V} \times k_{e}) + (\frac{D}{V} \times k_{d} \times (1 - T)) + (\frac{P}{V} \times k_{p})$ Where:

$E$ = Market value of equity
$D$ = Market value of debt
$P$ = Market value of preferred stock
$V = E + D + P$ (Total capital)
$T$ = Corporate tax rate

Worked Example: Kathmandu Travel Agency

Given:

Equity (E) = Rs. 5,00,000 (10,000 shares at Rs. 50 each)
Debt (D) = Rs. 3,00,000 (loan at 10% interest)
Preferred Stock (P) = Rs. 2,00,000 (12% dividend)
Tax Rate (T) = 20%
$k_{e} = 15%$ (from CAPM)
$k_{p} = 12%$

T-account showing equity financing for the worked example.

Step 1: Calculate Weights $Weight of Equity = \frac{5 , 00 , 000}{10 , 00 , 000} = 0.5$ $Weight of Debt = \frac{3 , 00 , 000}{10 , 00 , 000} = 0.3$ $Weight of Preferred Stock = \frac{2 , 00 , 000}{10 , 00 , 000} = 0.2$

Step 2: Adjust for Tax on Debt $k_{d} \times (1 - T) = 10% \times 0.8 = 8%$

Step 3: Compute WACC $W A C C = (0.5 \times 15%) + (0.3 \times 8%) + (0.2 \times 12%) = 7.5% + 2.4% + 2.4% = 12.3%$

Interpretation: The agency must earn at least 12.3% on new projects to justify their cost of capital.

4. How WACC is Used in Decision-Making

WACC is the hurdle rate for capital budgeting:

If a project’s expected return > WACC, accept it (creates value).
If expected return < WACC, reject it (destroys value).

Example: Should Hotel Everest Expand?

Project	Expected Return	WACC (12%)	Decision
New Spa Wing	14%	12%	Accept
Conference Hall Upgrade	10%	12%	Reject
Rooftop Restaurant	13%	12%	Accept

In the Real World

eSewa (Digital Payments)
- Uses WACC to decide whether to expand its loan services. If the expected return on a new loan product is higher than eSewa’s WACC (say, 14% vs. 12%), it proceeds. Lower returns mean rejecting the project to avoid shareholder value destruction.
Nepal Stock Exchange (NEPSE) Listings
- Companies like Cement India (Nepal) or Nabil Bank disclose their cost of equity in annual reports. Investors use this to compare expected returns. For example, if a company’s $k_{e} = 16%$ but its projects yield only 10%, it signals poor management.
Pathao (Ride-Hailing)
- Pathao’s expansion into electric vehicles relies on WACC-based financing. If its cost of capital is 15% and EV projects promise 18% returns, it borrows more. If returns drop below WACC, it cuts losses (as seen in 2022 when some ride-hailing firms in Nepal struggled).

5. Factors Affecting Cost of Capital

Factor	Effect on Cost of Capital	Example
Market Risk (β)	Higher β → Higher $k_{e}$	NEPSE’s volatile stocks have higher $k_{e}$ than fixed-income bonds.
Tax Rates	Higher taxes → Lower $k_{d}$ (after-tax cost)	Nepal’s 20% corporate tax reduces debt cost.
Financial Leverage	More debt → Higher risk → Higher $k_{e}$	Highly leveraged hotels (e.g., Radisson) face higher equity costs.
Inflation	Higher inflation → Higher expected returns	In 2023, Nepal’s inflation pushed $k_{e}$ up.
Investor Sentiment	Pessimism → Higher required returns	During COVID-19, $k_{e}$ spiked for tourism firms.

6. Marginal Cost of Capital (MCC)

As a company raises more capital, its cost increases due to:

Higher risk (investors demand more for additional funds).
Changing capital structure (more debt → higher $k_{e}$ ).

MCC Curve vs. Investment Opportunity Schedule (IOS)

MCC curve intersects IOS at Projects 1 & 2 (accepted); Project 3 rejected.

Example:

Project A: 18% return → Accept (WACC = 12%)
Project B: 15% return → Reject (MCC rises to 14%)

7. Cost of Capital for Tourism Businesses

Tourism firms (hotels, travel agencies, airlines) face unique challenges:

High fixed costs (staff, infrastructure) → Higher debt risk → Higher $k_{d}$ .
Seasonal revenue → Investors demand higher $k_{e}$ .
Regulatory risks (e.g., visa policies) → Higher perceived risk.

Worked Example: Himalayan Airlines

Given:

Equity: Rs. 80,00,000 (200,000 shares at Rs. 400)
Debt: Rs. 40,00,000 (9% loan)
Preferred Stock: Rs. 20,00,000 (10% dividend)
Tax Rate: 25%
$k_{e} = 16%$ (high due to aviation risk)
$k_{p} = 10%$

WACC Calculation: $W A C C = (\frac{80}{140} \times 16%) + (\frac{40}{140} \times 9% \times 0.75) + (\frac{20}{140} \times 10%)$ $= 9.14% + 1.93% + 1.43% = 12.5%$

Decision:

New Fleet Purchase: Expected return = 14% → Accept (14% > 12.5%)
Luxury Lounge Upgrade: Expected return = 11% → Reject (11% < 12.5%)

Exam Tip

Memorize WACC Formula: Always adjust debt for taxes ( $k_{d} \times (1 - T)$ ).
Practice Calculations: TU/PU exams often test WACC with missing values (e.g., given $k_{e}$ but not weights).
Compare Projects: Questions may ask which project to choose based on WACC (e.g., "Which of these has the highest NPV?").
Real-World Application: Relate to Nepali businesses (e.g., "How would Nabil Bank use WACC to decide on a new loan product?").
Common Pitfalls:
- Forgetting to weight components by their market value.
- Ignoring tax shields on debt.
- Using book value instead of market value for equity/debt.

Visual Summary: Accounting Cycle for Cost of Capital

Based on the TU BTTM syllabus for Business Finance, unit 6.

Discussion

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