How do you compute the weighted average cost of capital (WACC) for a company?

How do you compute the weighted average cost of capital (WACC) for a company?

• A. WACC = (E/V)*Re + (D/V)*Rd*(1-Tc) + (P/V)*Rp; where E, D, P are market values and V = E+D+P.
• B. WACC = Cost of equity only.
• C. WACC = 0.5 * cost of debt.
• D. WACC uses tax rate only.

Answer: (D)

WACC represents the overall cost of financing a company from all its sources—equity, debt, and any preferred stock—weighted by how much each source contributes to the total capital. The idea is to blend the costs of each component in proportion to its market value share in the company’s capital structure. For the calculation, you take the cost of each source: Re for equity, Rd for debt, and Rp for preferred stock. Then you weight them by their market-value shares: E/V for equity, D/V for debt, and P/V for preferred, with V = E + D + P. The debt portion is multiplied by (1 − Tc) because interest is tax-deductible, creating a tax shield that lowers the after-tax cost of debt. The combined formula is (E/V)*Re + (D/V)*Rd*(1 − Tc) + (P/V)*Rp. This approach is why WACC considers both the costs and the mix of financing. It’s not just the cost of equity, nor a simple fraction of debt, and it won’t be accurate if you ignore the tax shield or the other capital sources.

WACC represents the overall cost of financing a company from all its sources—equity, debt, and any preferred stock—weighted by how much each source contributes to the total capital. The idea is to blend the costs of each component in proportion to its market value share in the company’s capital structure.

For the calculation, you take the cost of each source: Re for equity, Rd for debt, and Rp for preferred stock. Then you weight them by their market-value shares: E/V for equity, D/V for debt, and P/V for preferred, with V = E + D + P. The debt portion is multiplied by (1 − Tc) because interest is tax-deductible, creating a tax shield that lowers the after-tax cost of debt. The combined formula is (E/V)*Re + (D/V)Rd(1 − Tc) + (P/V)*Rp.

This approach is why WACC considers both the costs and the mix of financing. It’s not just the cost of equity, nor a simple fraction of debt, and it won’t be accurate if you ignore the tax shield or the other capital sources.