Financial Management and Strategic Management · Financing Decisions - Capital Structure

Weighted Average Cost of Capital (WACC) for CA Inter FM

Updated 4 October 2026 · Fact-checked

WACC is the average cost of all long-term funds of a firm, with each source weighted by its share in total capital. Find the after-tax cost of each source, choose book or market value weights, multiply cost by weight, and add. Marginal cost of capital uses target or new-fund weights.

Understand Weighted Average Cost of Capital (WACC)

A company raises money from equity, preference shares, debentures and loans. Each source has a different cost. The firm needs one single figure to judge projects. That figure is the Weighted Average Cost of Capital (WACC).

WACC is a weighted average. A source that forms a bigger part of the capital gets a bigger weight. If debt is 40% of capital at a cost of 7% after tax, it adds 2.8% (0.40 × 7%) to WACC.

The weights can be book value (from the balance sheet) or market value (current market price × number of securities). Book weights are easy and stable. Market weights show what investors would need to be paid today, so they are theoretically better. Market value of equity is usually well above book value, so market weights raise the share of equity and usually raise WACC, since equity costs more than debt.

The marginal cost of capital (MCC) is the cost of raising one more rupee of new capital. It is calculated with the weights of the new funds being raised (or the target capital structure), using the current cost of each new source. It is the right rate when you evaluate a new project funded by a new issue.

Retained earnings are included as a source of equity. Cost of debt must always be taken after tax. Preference dividend and equity dividend are not tax-deductible, so no tax adjustment is made for them.

Key rules to remember

WACC: WACC (Ko) = Σ (Wi × Ki) = (E × Ke + P × Kp + D × Kd(1 − t) + R × Kr) ÷ Total capital; Wi is the weight of each source and Ki its cost. Weights must add up to 1 (or 100%). Use after-tax cost of debt.
After-tax cost of debt: Kd(1 − t) = Kd × (1 − tax rate); Kd is the pre-tax cost. For irredeemable debt, Kd = Interest ÷ Net proceeds (or market price).
Book value weight: Weight of a source = Book value of that source ÷ Total book value of capital; Use balance-sheet figures at face or carrying value, as given.
Market value weight: Market value of a source = Market price per security × Number of securities; Weight = That value ÷ Total market value; If retained earnings are given with market value of equity, do not add them again; the market price already reflects them.
Marginal cost of capital: MCC = Σ (Proportion of new funds from each source × Cost of that new source); Use the proportions of the new financing package or the target structure, and the current cost of new funds.

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

Use this order for any WACC or MCC question. It keeps the working tidy and earns step marks.

1Read which weights are asked: book value, market value, or target or marginal proportions. Note the tax rate.
2List every source of capital: equity, retained earnings, preference, debentures, term loans. Ignore current liabilities unless the question includes them.
3Compute the cost of each source separately using its own formula. Convert debt to after-tax cost.
4Compute the amount of each source on the required basis. For market value, use price × number of securities.
5Find the weights: each amount ÷ total. Check that they add up to 100%.
6Build a table with columns: Source, Amount, Weight, Cost, Weighted cost. Multiply and add the last column.
7State WACC as a percentage, and add one line of interpretation, such as the minimum return a project must earn.

Quickest way: Table-first method for WACC and MCC

When to use it: Use it for every numerical question, especially in the 70-mark written section where step marks matter, and for quick MCQ checks.

Draw the five-column table at once: Source, Amount, Weight, Cost, Weighted cost.
Write after-tax Kd before anything else. Forgetting it is the commonest loss.
Skip the weight column and compute Σ (Amount × Cost) ÷ Total amount. This avoids rounding errors in weights.
For MCQs, estimate: WACC always lies between the lowest and the highest cost. Eliminate any option outside that range.
Also, if market value of equity exceeds book value and Ke is highest, market-weight WACC will be higher than book-weight WACC. Use this to eliminate options.
For MCC, use only new funds and their current costs. Do not mix in old capital unless the question asks for overall WACC.

Common mistakes in Weighted Average Cost of Capital (WACC)

Using pre-tax cost of debt in WACC
Students copy the interest rate directly from the question.
Fix: Always write Kd(1 − t) first. Tax shield applies only to interest, not to dividends.
Using book value of equity when market weights are asked
The balance sheet is in front of you and looks easier.
Fix: Read the question for the word market. Compute price × number of shares for each security.
Adding retained earnings again to market value of equity
Students treat reserves as a separate source in every case.
Fix: In a market-value table, the market price of equity already reflects retained profits. Show reserves separately only on a book-value basis.
Weights that do not add up to 100%
A source is missed or amounts are mis-added.
Fix: Total the amounts first and check the weights sum to 1 before multiplying.
Using old costs and old weights for MCC
MCC is confused with overall WACC.
Fix: MCC uses the proportions of the new funds and the current cost of each new source.
Ignoring flotation cost or discount in the cost of debentures or shares
Students use the face value as proceeds.
Fix: Use net proceeds (price less issue cost or discount) in the denominator, when the question gives these.

Worked examples

Example 1

A company has the following capital structure: Equity share capital (₹10 shares) ₹40,00,000; 10% Preference share capital ₹10,00,000; 12% Debentures ₹30,00,000; Retained earnings ₹20,00,000. Cost of equity is 15% and the cost of retained earnings is also 15%. Preference shares and debentures are issued and redeemable at par, with no issue costs. Tax rate is 25%. Compute WACC using book value weights.

Show the solution

Cost of debt after tax = 12% × (1 − 0.25) = 9%.
Cost of preference = 10%. Cost of equity = 15%. Cost of retained earnings = 15%.
Total capital = 40,00,000 + 10,00,000 + 30,00,000 + 20,00,000 = ₹1,00,00,000.
Weighted cost: Equity 40,00,000 × 15% = ₹6,00,000. Preference 10,00,000 × 10% = ₹1,00,000. Debentures 30,00,000 × 9% = ₹2,70,000. Retained earnings 20,00,000 × 15% = ₹3,00,000.
Total = 6,00,000 + 1,00,000 + 2,70,000 + 3,00,000 = ₹12,70,000.
WACC = 12,70,000 ÷ 1,00,00,000 = 12.7%.

Answer: WACC on book value weights = 12.7%.

Example 2

Using the data of the previous question, the market price of an equity share is ₹30 (4,00,000 shares), the 10% preference shares (face value ₹100, 10,000 shares) are quoted at ₹100 each, and the 12% debentures (face value ₹100, 30,000 debentures) are quoted at ₹100 each. Cost of equity remains 15%, and the figures for cost of preference and debt are unchanged. Calculate WACC using market value weights. Then, for new financing of ₹20,00,000 raised as 50% equity at a cost of 16% and 50% debt at a pre-tax cost of 14%, find the marginal cost of capital.

Show the solution

Market value of equity = 4,00,000 × ₹30 = ₹1,20,00,000. Retained earnings are not added separately, as the market price reflects them.
Market value of preference = 10,000 × ₹100 = ₹10,00,000.
Market value of debentures = 30,000 × ₹100 = ₹30,00,000.
Total market value = 1,20,00,000 + 10,00,000 + 30,00,000 = ₹1,60,00,000.
Weighted cost: Equity 1,20,00,000 × 15% = ₹18,00,000. Preference 10,00,000 × 10% = ₹1,00,000. Debentures 30,00,000 × 9% = ₹2,70,000.
Total = 18,00,000 + 1,00,000 + 2,70,000 = ₹21,70,000.
WACC = 21,70,000 ÷ 1,60,00,000 = 13.5625%, about 13.56%.
MCC: after-tax cost of new debt = 14% × 0.75 = 10.5%.
MCC = 0.50 × 16% + 0.50 × 10.5% = 8% + 5.25% = 13.25%.

Answer: WACC on market value weights is about 13.56%. Marginal cost of capital for the new ₹20,00,000 is 13.25%.

Exam tips

Read the question for the weight basis. Book, market and marginal are three different answers and ICAI often asks for two of them together.
Show the table with all columns. Even if a cost is wrong, correct method earns step marks.
Write the cost-of-debt tax adjustment as a separate line so the examiner can see it.
Write one line of interpretation, such as a project should be accepted only if its return is above the WACC.
In MCQs, check that your answer lies between the lowest and highest cost of capital before marking it.

Practice questions from Financing Decisions - Capital Structure

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

Which is better for WACC, book value or market value weights?

Market value weights are theoretically better because they reflect what investors currently expect. Book value weights are simpler and more stable. In the exam, follow what the question asks, and if it gives market prices and asks for market weights, use them.

What is the difference between WACC and marginal cost of capital?

WACC is the average cost of the whole existing capital structure. Marginal cost of capital is the cost of the next rupee raised, using the weights of the new funds and current costs. Use MCC to judge a new project funded by a fresh issue.

Do I use after-tax or pre-tax cost of debt in WACC?

Use after-tax cost, Kd × (1 − t), because interest is tax-deductible. Do not apply tax to preference or equity costs, since dividends are paid out of post-tax profit.

Should retained earnings be included in WACC?

Yes, on a book value basis, as a source of equity with its own cost. On a market value basis, the market value of equity already reflects retained profits, so do not add them again.