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  1. 094A company is funded 70% by equity costing 14% and 30% by debt costing 9% before tax. The tax rate is 25%. What is its weighted average cost of capital?Cost of capital and ratesWarm upSell-side equity researchIndian brokerage research

    Try it first

    Pick the WACC.

    Show the worked solution

    About 11.8%. Weight each source of money by its share and use debt after tax. Equity contributes 70% of 14%, 9.8 points. Debt costs 9% before tax but only 9% times 75%, 6.75%, after it, so it contributes 30% of 6.75%, about 2.0 points. The total is 11.825%. Using debt before tax would overstate WACC at 12.5%.

    Why is WACC a weighted average rather than a simple one?

    A household that pays for a flat with 70% of its own savings and a 30% home loan has a blended cost of money closer to what its savings could have earned than to the loan rate, because most of the money is savings. WACC weights each source by its share of the funding, measured at market value, because that is the mix the company's investments must pay for. A simple average of 14% and 9% would give debt far more say than 30% of the money deserves.

    Why does the tax rate touch only the debt?

    Interest is deducted before tax is worked out; dividends are not. So every Rs 100 of interest cuts the tax bill by Rs 25, and debt at 9% really costs the company 9% times 75%, which is 6.75%. The tax shieldThe reduction in tax a company gets because interest is deductible: interest times the tax rate. is why WACC uses the after-tax cost of debt, and why the equity cost stays as it is. Confirm the applicable tax rate for the company before using a headline figure.

    WACC is the area: each source's weight times its after-tax cost0%5%10%15%Equity, 70% of fundingcosts 14%0.70 x 14% = 9.8 pointstax shield -2.25Debt, 30%9% x (1 - 25%) = 6.75%0.30 x 6.75% = 2.02512.5% pre-taxdebt: wrongWACC 11.8%Width = share of funding at market value; height = cost to the company after tax9.8 + 2.025 = 11.825%, about 11.8%
    Equity at 70% of funding and a 14% cost contributes 9.8 points and debt at 30% and an after-tax cost of 6.75% contributes 2.025, so WACC is about 11.8%, while using debt before tax would wrongly give 12.5%.
    The relationship
    WACC=wEkE+wDkD(1−t)=0.7×14%+0.3×9%×0.75≈11.8%WACC = w_E k_E + w_D k_D (1 - t) = 0.7 \times 14\% + 0.3 \times 9\% \times 0.75 \approx 11.8\%
    w_E, w_Dshares of equity and debt in the funding, at market value
    k_E, k_Dcost of equity and pre-tax cost of debt
    tthe tax rate, 25%
    What it says in wordsWeight each source's cost by its share of the money, and cut the cost of debt by the tax it saves.

    What would make you distrust this number?

    The weights and the inputs both move. Weights should be market values, not book values, and they should reflect the mix the company will hold over the forecast, not a single year-end snapshot. Adding debt does not lower WACC forever: as borrowing rises, lenders charge more and shareholders demand more for the extra risk. And the tax shield only exists if the company has profits to shield. A loss-making company's debt costs the full 9%, which would lift WACC to 12.5%.

    Where candidates lose it

    The fast wrong answer is 12.5%, using debt before tax. Candidates remember the formula but drop the one term that makes debt cheaper.

    The second loss is applying the tax rate to equity as well, or using book weights without saying so. State market weights and after-tax debt in the first sentence and the interviewer moves on.

    What the interviewer asks next

    • What happens to WACC if the company moves to 50% debt and the cost of equity rises to 16%?
    • Why should you use market weights rather than book weights?
    • How does WACC change for a company that pays no tax because of past losses?