Business Finance · Cost of capital and evaluating investment projects

Weighted Average Cost of Capital (WACC): Formula and Steps

Updated 11 October 2026 · Fact-checked

WACC is the average cost of a company's finance, with each source weighted by its market value. Work out the cost of each source (debt after tax), find market values, compute weights, then add weight × cost. Use it as the discount rate only for projects with the firm's average risk and gearing.

Understand Weighted Average Cost of Capital (WACC)

A company raises money from different sources, mainly equity and debt. Each source has a cost. Equity holders expect a return for bearing risk. Lenders expect interest. A project must earn enough to pay all of them, so the discount rate for the project should reflect the cost of the whole mix of finance.

WACC does this. It averages the cost of each source, using weights based on how much of the total finance each source provides. The cost of debt is taken after tax, because interest is normally tax-deductible. The cost of equity is not adjusted, because dividends are paid out of post-tax profit.

Use market values for the weights, not book values. Market values show what investors would require today. A share bought at ₹10 years ago may now trade at ₹60. Book value would understate equity and overstate the weight on debt. Market value of equity is the number of shares × share price. Market value of debt is the price of the bonds × the number of bonds, or the present value of the payments at the current yield.

WACC is a valid discount rate for a project only under conditions. The project should have the same business risk as the firm's existing operations. The firm should keep its capital structure, in market-value terms, roughly constant. The finance raised should not change the firm's risk. If the project is riskier, or financed in a very different way, use a rate that reflects the project's own risk.

In exams, you will usually be given the share price, number of shares, dividends or a CAPM input, bond price and coupon, and the tax rate. The task is to organise this data and avoid the traps: pre-tax debt cost, book weights, and missing sources of finance.

Key rules to remember

WACC: WACC = [E ÷ (E + D)] × ke + [D ÷ (E + D)] × kd × (1 − t); E and D are market values of equity and debt. ke is the cost of equity, kd the pre-tax cost of debt, t the corporate tax rate. Extend with more terms if there is preference capital.
Market value of equity: E = number of shares × current share price; Use ex-dividend prices. Do not use nominal value or book value.
Cost of equity (CAPM): ke = rf + β × (rm − rf); rf is the risk-free rate, rm the expected market return, β the equity beta.
Cost of equity (dividend growth model): ke = D1 ÷ P0 + g; D1 is next year's dividend, P0 the current ex-dividend price, g the constant growth rate. Assumes constant growth forever.
After-tax cost of debt: kd(1 − t) where kd is the redemption yield; Find the yield from the bond price, coupon and redemption value. This is the rate r with price = PV of coupons and redemption at r. Assumes interest is fully tax-deductible and the firm pays tax.
Weight of a source: weight = market value of the source ÷ total market value of all finance; Weights must add up to 1.

How to solve Weighted Average Cost of Capital (WACC) questions

Follow these steps for any WACC question. They keep your working clear and make method marks easy to award.

1List every source of long-term finance in the question: ordinary shares, preference shares, bonds, loans.
2Find the market value of each source. For equity, shares × price. For bonds, price × number of bonds, or the present value of cash flows.
3Calculate the cost of each source. Use CAPM or the dividend growth model for equity, and the redemption yield for debt.
4Adjust the cost of debt for tax: multiply by (1 − t). Do not adjust equity or preference share costs.
5Compute the weights: each market value divided by the total.
6Multiply each weight by its cost and add the results to get WACC.
7State the assumptions: project risk equals firm risk, and capital structure stays constant. Then use WACC as the NPV discount rate, if asked.

Quickest way: Table method with total market value

When to use it: Use this when you have two or three sources and numbers are given in one currency. It reduces slips under time pressure.

Draw three columns: market value, cost after tax, value × cost.
Fill in market values in rupees and total them.
Fill in after-tax costs. Debt gets × (1 − t).
Multiply each market value by its cost and add the results.
Divide the total by the total market value. This gives WACC without calculating weights separately.
Sense check: WACC must lie between the lowest and highest source cost, and normally closer to the cost of the larger source.

Common mistakes in Weighted Average Cost of Capital (WACC)

Using the pre-tax cost of debt in WACC.
Students memorise the yield calculation and forget the tax shield on interest.
Fix: Always write kd × (1 − t) in the formula line before substituting numbers. Tick it off as a checklist item.
Using book values for weights.
Book values appear on the balance sheet and are easy to find.
Fix: Use market values unless the question says only book values are available. Equity market value = shares × price.
Taking the coupon rate as the cost of debt.
The coupon is stated clearly, while the yield needs a calculation.
Fix: Cost of debt is the current redemption yield. It equals the coupon only if the bond trades at its redemption value.
Ignoring a source of finance such as preference shares.
Students focus on equity and debt and skip the rest of the question data.
Fix: Underline every financing item in the question. Check that the weights sum to 1.
Applying WACC to every project regardless of risk.
WACC is presented as 'the discount rate' without its conditions.
Fix: State that WACC suits projects with average business risk and unchanged gearing. Otherwise adjust the rate for the project's risk.
Using the cum-dividend price or mixing up D0 and D1 in the dividend growth model.
The model looks simple and students rush the inputs.
Fix: Use D1 = D0 × (1 + g) and the ex-dividend price P0. Check which dividend the question gives.

Worked examples

Example 1

A company has 2 crore ordinary shares trading at ₹50 each. It also has ₹30 crore (market value) of bonds. The cost of equity is 14% and the pre-tax cost of debt is 9%. The tax rate is 25%. Calculate the WACC.

Show the solution

Market value of equity: 2 crore × ₹50 = ₹100 crore.
Market value of debt: ₹30 crore. Total = ₹130 crore.
Weights: equity = 100 ÷ 130 = 0.7692; debt = 30 ÷ 130 = 0.2308.
After-tax cost of debt = 9% × (1 − 0.25) = 6.75%.
WACC = 0.7692 × 14% + 0.2308 × 6.75%.
Equity part = 10.769%. Debt part = 1.558%.
WACC = 10.769% + 1.558% = 12.33% (approximately).

Answer: WACC ≈ 12.3%

Example 2

A firm has 50 lakh shares at ₹80 each. Its equity beta is 1.2, the risk-free rate is 6% and the expected market return is 11%. It has 1 lakh bonds of face value ₹1,000, redeemable at par, with a market price of ₹1,000 and a coupon of 8%. The tax rate is 30%. A project of average risk has an initial outlay of ₹20 crore and gives a single net cash inflow of ₹26 crore after one year. Find the WACC and decide whether to accept the project using NPV.

Show the solution

Cost of equity by CAPM: ke = 6% + 1.2 × (11% − 6%) = 6% + 6% = 12%.
Market value of equity: 50 lakh × ₹80 = ₹40 crore.
Market value of debt: 1 lakh × ₹1,000 = ₹1 crore. Check this carefully: 1 lakh = 1,00,000, so 1,00,000 × 1,000 = ₹10 crore.
Debt is ₹10 crore. Total = ₹50 crore.
Weights: equity = 40 ÷ 50 = 0.8; debt = 10 ÷ 50 = 0.2.
The bond trades at par, so the pre-tax cost of debt equals the coupon, 8%. After tax = 8% × 0.7 = 5.6%.
WACC = 0.8 × 12% + 0.2 × 5.6% = 9.6% + 1.12% = 10.72%.
The project has average risk, so use WACC. NPV = 26 ÷ 1.1072 − 20 = 23.482 − 20 = ₹3.48 crore (approximately).

Answer: WACC = 10.72%. NPV ≈ +₹3.48 crore, so accept the project, assuming average risk and unchanged gearing.

Exam tips

Write the formula and the weights before calculating. Method marks are given even if arithmetic slips.
Show the market value calculation for each source. Examiners look for market values, not book values.
In written parts, always state the assumptions behind using WACC: same business risk, constant capital structure, and small project size relative to the firm.
In MCQs, check the traps first: after-tax debt cost, weights summing to 1, and whether the price is ex-dividend.
If asked when WACC is inappropriate, give two points: different project risk and a change in financing mix, and say what you would use instead.

Practice questions from Cost of capital and evaluating investment projects

Weighted Average Cost of Capital (WACC) in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Weighted Average Cost of Capital (WACC): frequently asked questions

Why are market values used for WACC weights?

Market values show what investors currently require from each source. Book values reflect historic cost and can be far from today's values. WACC is a forward-looking discount rate, so current values are the right basis.

Why is the cost of debt adjusted for tax but not the cost of equity?

Interest is normally deductible before tax is calculated, so the firm's net cost is lower. Dividends are paid from profit after tax and give no tax saving. That is why only debt gets the (1 − t) factor.

When is WACC appropriate for project appraisal?

Use it when the project has the same business risk as the firm's existing activities. The firm's capital structure should also stay broadly unchanged. If either condition fails, use a rate that reflects the project's own risk and financing.

What if the bond is trading at a price different from par?

Then the coupon is not the cost of debt. Find the redemption yield, the rate that makes the present value of the coupons and redemption payment equal to the market price. Then multiply that yield by (1 − t).