101 Concepts for the Level I Exam

Concept 61: Weighted Average Cost of Capital (WACC)

It is the overall cost of the sources of capital.
Represents the required return or opportunity costs for the firm as a whole.
It is the appropriate discount rate for cash flows of projects having similar risk profile as that of the firm.
Has weights that are derived from target capital structure and market values of each source of capital.
Is also called the marginal cost of capital (MCC)

$WACC=w_dr_d\left(1-t\right)+w_pr_p+w_er_e$

A firm has the following capital structure: 20% debt, 10% preferred stock, and 70% equity. The before-tax cost of debt is 6%, cost of preferred stock is 8%, and cost of equity is 12%. The firm’s marginal tax rate is 30 percent. Calculate its WACC.

Solution:

The WACC can be calculated using the formula.

WACC = (0.2) (0.06) (1 – 0.3) + (0.1) (0.08) + (0.7) (0.12) = 10.04%