Question

Weighted average cost of capital (WACC) is an important consideration in capital budgeting

and valuing options. What is WACC, and how is the basic WACC calculated?

Answer

The weighted average cost of capital (WACC) is a common method in the financial

management examination. In addition, it is an important consideration in capital budgeting

and valuing options. Therefore, this rate, also called the discount rate, is used in evaluating

whether a project is feasible or not in the net present value (NPV) analysis, or in assessing the

value of an asset.

In the text Corporate Finance, Berk and Demarzo (2010) conclude that the WACC

method takes the interest shield into account by using the after-tax cost of capital as the

discount rate. When the market risk of the plan is similar to the average market risk of the

firm’s investments, then its cost of capital is equivalent to the firm’s weighted average cost of

capital. The WACC incorporates the advantage of the interest tax shield by using the firm’s

E D
after-tax expenditure of capital for liability: rwacc = r E+ r (1 – τc). In this formula,
E+ D E+ D D

E is market value of equity; D is market value of debt; τc is marginal corporate tax rate; r E is

equity cost of capital; r D is debt cost of capital (p. 596).

In fact, this rate is used in the assessment of a project NPV or in determining the value

of an asset. However, why is WACC important? For a project to be feasible, not just

advantageous, it must create a return higher than the cost of raising debt (Rd) and the cost of

raising equity (Re). Moreover, WACC is affected not only by Re and Rd, but it also varies

with capital structure. Because Rd is usually lower than Re, then the higher the debt level, the
lower the WACC. This partly explains why firms usually prefer issuing debt first before they

raise more equity.

References

Berk, Jonathan & Demarzo, Peter. (2010). Corporate finance (2nd ed.). Upper Saddle River,

NJ: Prentice Hall.