Definition
Weighted Average Cost of Capital (WACC)
A company's blended cost of capital across all its funding sources, weighted by each source's share of the capital structure: WACC = (E/V) x Re + (D/V) x Rd x (1 - T). E/V and D/V are the equity and debt weights (each divided by total capital V = E + D), Re is the cost of equity, Rd is the pre-tax cost of debt, and T is the tax rate. Only the debt component is multiplied by (1 - T) because interest is tax-deductible while dividends are not, so debt carries a tax shield that equity does not. WACC is commonly used as the discount rate in discounted cash flow valuation and as a firm's hurdle rate for capital-budgeting decisions: a project is accepted if its IRR exceeds WACC and rejected if it falls short.
A company is 60% equity financed with a 10% cost of equity, and 40% debt financed with a 5% pre-tax cost of debt, at a 25% tax rate. WACC = (0.60 x 10%) + (0.40 x 5% x (1 - 0.25)) = 6.00% + 1.50% = 7.50%. The company would use 7.50% as its discount rate for capital-budgeting decisions.
The tax adjustment applies only to the debt term, never the equity term; a common error is applying (1 - T) to the whole formula or to the equity component. Also worth keeping straight: WACC is a specific calculation method a company uses to arrive at a discount rate or hurdle rate, not a synonym for either term. A firm can choose to use something other than its WACC as a hurdle rate (for example, adding a risk premium for an unusually risky project), even though WACC is the most common starting point.
How is Weighted Average Cost of Capital (WACC) tested on the exam?
- Calculating WACC from equity weight, cost of equity, debt weight, pre-tax cost of debt, and tax rate
- Applying the tax shield correctly: only the debt component is multiplied by (1 - tax rate)
- Calculating the after-tax cost of debt as a standalone step before combining it into WACC
- Recognizing WACC as a common source for a company's hurdle rate or DCF discount rate
- Applying the accept/reject rule: accept a project if its IRR exceeds WACC, reject if it falls short
Calculation example
Calculation Example
WACC = (E/V) x Re + (D/V) x Rd x (1 - T) - Identify the equity component: 0.60 x 10% = 6.00%
- Compute the after-tax cost of debt: 5% x (1 - 0.25) = 3.75%
- Identify the debt component: 0.40 x 3.75% = 1.50%
- Add the two components: 6.00% + 1.50% = 7.50%
WACC is a company mixing its own cocktail of funding: some parts equity, some parts debt, blended by how much of each it pours in. The debt part gets a tax discount (interest is deductible) that the equity part never gets, since dividends get no such break from the IRS.
Practice questions
Test your understanding with the questions below. Pick an answer to reveal the explanation.
A firm's WACC is 9%, which it uses as its hurdle rate for new projects. A proposed factory expansion has a projected IRR of 11%. Based on this information alone, what should the firm do?
A is correct. The project's IRR (11%) exceeds the firm's 9% WACC-based hurdle rate, so it clears the bar and should be accepted; its NPV at a 9% discount rate would be positive.
B dismisses a valid return with no support. C misstates the decision rule; a zero NPV signals indifference, not the acceptance threshold. D is an unsupported claim; WACC applies broadly across a firm's capital projects, not to specific categories only.
WACC-as-hurdle-rate questions are a staple of capital-budgeting content: compare a project's IRR to WACC and apply the same accept/reject logic used for any other required rate of return.
The weighted average cost of capital (WACC) is best described as:
A is correct. WACC blends the cost of equity and the after-tax cost of debt, weighted by each source's proportion of total capital.
B describes the unrelated Federal Reserve discount rate. C describes a bond-specific yield measure unrelated to a company's overall capital structure. D describes a peer-comparison dividend metric, not a cost-of-capital calculation.
Confusing WACC with an unrelated interest rate or yield concept is a common wrong-answer trap; WACC is specifically a blended, capital-structure-weighted figure.
A firm is 50% equity, with a 12% cost of equity, and 50% debt, with an 8% pre-tax cost of debt, at a 25% tax rate. The firm's WACC is closest to:
B is correct. After-tax cost of debt = 8% x (1 - 0.25) = 6%. WACC = (0.50 x 12%) + (0.50 x 6%) = 6.0% + 3.0% = 9.0%.
A understates the equity contribution. C skips the tax adjustment on debt, using the pre-tax 8% rate directly: (0.50 x 12%) + (0.50 x 8%) = 10.0%. D simply adds the two raw rates (12% + 8%) without weighting by capital structure.
Option C isolates the single most common WACC calculation error on the exam: forgetting to apply the tax shield to the debt component before weighting it.
All of the following statements about WACC are accurate EXCEPT
C is correct (the EXCEPT answer). Debt is often cheaper than equity due to the tax shield, but adding more debt increases financial risk, which can raise both the cost of debt and the cost of equity, offsetting the apparent savings; WACC does not fall without limit as debt increases.
A is accurate: only the debt term gets the (1 - T) adjustment, since interest, not dividends, is tax-deductible. B is accurate: WACC is a standard DCF discount rate. D is accurate: E/V and D/V are the capital-structure weights.
The exam tests whether you understand that WACC minimization has a limit: piling on debt for a lower blended rate ignores the rising financial risk that debt itself creates.
A company's WACC formula includes an equity component and a debt component. Which of the following statements about this formula are accurate?
1. The equity component is the cost of equity multiplied by the equity weight (E/V)
2. The debt component is multiplied by (1 minus the tax rate)
3. The equity component is also multiplied by (1 minus the tax rate)
4. WACC can be used as a company's hurdle rate for evaluating new projects
B is correct. Statements 1, 2, and 4 are accurate.
Statement 1 is TRUE: the equity component is Re x (E/V). Statement 2 is TRUE: the debt component gets the (1 - T) tax-shield adjustment. Statement 3 is FALSE: the equity component is NOT tax-adjusted, since dividends aren't tax-deductible the way interest is. Statement 4 is TRUE: WACC is a standard hurdle rate for capital-budgeting decisions.
Statement 3 targets the exact error the exam most often tests: applying the tax shield to the wrong side of the formula.
Where does Weighted Average Cost of Capital (WACC) appear on the Series 65 exam?
This term is tested in the following Series 65 exam topics: