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  1. 056A company is funded 60% by equity at a 14% cost and 40% by debt at 10% before tax, and the tax rate is 25%. What is its weighted average cost of capital?DCF and cost of capitalWarm upBulge bracket IBMiddle market IB

    Try it first

    Pick the WACC.

    Show the worked solution

    The WACC is 11.4%. Equity is 60% of the funding at 14%, contributing 8.4 points. Debt is 40% at 10% before tax, but interest is tax-deductible, so its after-tax cost is 10% x (1 minus 25%) = 7.5%, contributing 3.0 points. Add them: 8.4 + 3.0 = 11.4%. Leaving out the tax shield gives 12.4%.

    Why is it a weighted average and not a plain one?

    A family buying a flat with 60% from savings and 40% from a home loan pays a blended cost that leans towards the bigger source. Each source of money counts in proportion to how much of the funding it provides. Here equity provides 60 rupees in every 100, so its 14% carries more weight than debt's rate. A plain average of 14% and 10% would be 12.0%, which pretends the two sources are the same size.

    Weight each source by its share, and put debt in after tax60%40%FundingEquitycosts 14%Debt10% before taxx (1 - 25%) = 7.5%3.08.40.4 x 7.5% = 3.00.6 x 14% = 8.4Contribution, pointsWACC 11.4%the right answer12.4% if debtgoes in pre-tax
    Equity is 60% of funding at 14% and contributes 8.4 points; debt is 40% at 7.5% after tax and contributes 3.0 points, so the WACC is 11.4%. Using the 10% pre-tax rate adds a wrong extra point and gives 12.4%.

    Why does debt go in after tax?

    Interest is deducted before profit is taxed, so every 10 rupees of interest cuts the tax bill by 2.50 rupees at a 25% rate. The tax saved pays a quarter of the interest, so the company's true cost of debt is 7.5%, not 10%. That saving is the tax shieldThe tax a company avoids because interest is deducted from profit before tax is worked out.. Equity has no such shield, because dividends are paid out of profit after tax, which is why the adjustment sits on the debt term only.

    The relationship
    WACC=EV re+DV rd(1−t)=0.6(14%)+0.4(10%)(0.75)=11.4%\text{WACC} = \tfrac{E}{V}\,r_e + \tfrac{D}{V}\,r_d(1-t) = 0.6(14\%) + 0.4(10\%)(0.75) = 11.4\%
    E/Vequity's share of total funding, 60%
    D/Vdebt's share of total funding, 40%
    r_ecost of equity, 14%
    r_dpre-tax cost of debt, 10%
    ttax rate, 25%
    What it says in wordsWeight each source's cost by its share of the funding, and cut the cost of debt by the tax it saves.

    One more sentence wins the point. The weights should be market values, not the book values on the balance sheet, because investors demand a return on what their stake is worth today. Then say what the number is for: 11.4% is the rate at which you would discount the company's unlevered free cash flows in a DCF.

    Where candidates lose it

    The usual miss is forgetting the tax shield and answering 12.4%. It is the most common one-point error in a first-round cost of capital question, and interviewers ask it because it is so easy to skip.

    The second is applying the tax adjustment to equity as well, or to the whole WACC. The shield belongs to interest alone, so say which term it sits on.

    What the interviewer asks next

    • The company moves to 60% debt at the same rates. What happens to WACC, and why would the rates not stay the same?
    • Why is the cost of equity higher than the cost of debt?
    • If the company makes losses and pays no tax, what is its WACC?