CFA Level II Exam · Cost of Capital: Advanced Topics

WACC Formula and Marginal Cost of Capital for CFA Level II

Updated 7 October 2026 · Fact-checked

WACC is the average after-tax cost of a firm's financing, weighted by target market-value proportions of debt, preferred stock and common equity. Find the target weights, estimate each component cost, tax-adjust debt, then sum the weighted costs. Use the marginal cost of capital, the cost of the next unit of funds, to judge new projects.

Understand Cost of Capital Fundamentals and WACC Review

A firm raises money from debt holders, preferred shareholders and common shareholders. Each group wants a return for the risk it takes. The cost of capital is the return the firm must earn on its investments to satisfy these providers. If a project earns more than its cost of capital, it adds value.

The weighted average cost of capital (WACC) blends the component costs into one rate. Debt interest is tax deductible, so you use the after-tax cost of debt. Equity and preferred dividends are not deductible, so they enter at their stated cost.

Weights should reflect the target capital structure, measured at market values, not the book values on the balance sheet and not necessarily today's mix. The target is the mix the firm aims to hold over time. If the question gives a target, use it. If not, use the current market-value weights, or the industry average if the firm is moving toward it. Book values mislead because they record history, not what investors would pay today.

The marginal cost of capital (MCC) is the cost of raising one more unit of new capital. It can rise as the firm raises more funds, because investors demand higher returns or because cheaper sources run out. The point where the cost changes is a break point. Project evaluation should use the MCC that applies to the project's size and risk. Use the firm's WACC only if the project has average risk for the firm and is financed at the target mix.

On Level II, you rarely just plug numbers into a formula. The vignette gives market prices, tax rates, yields, betas and a target structure, and you must pick the right inputs. The next topics cover how to estimate each component in detail.

Key formulas to remember

Weighted average cost of capital: WACC = wd × rd × (1 − t) + wp × rp + we × re; Weights wd, wp, we are target market-value proportions and must sum to 1. rd is the pre-tax cost of debt; t is the marginal tax rate.
After-tax cost of debt: rd(after-tax) = rd × (1 − t); Use the current market yield on the firm's debt, not the old coupon rate.
Cost of equity (CAPM): re = Rf + β × (Rm − Rf); Rm − Rf is the equity risk premium. Use the beta that matches the project or firm risk.
Weights from debt-to-equity ratio: wd = (D/E) ÷ (1 + D/E); we = 1 ÷ (1 + D/E); Use when the vignette gives D/E. If given D/V, then we = 1 − wd.
Break point for marginal cost of capital: Break point = amount of capital at which a component's cost changes ÷ weight of that component; Example: if cheap debt is limited to ₹40 crore and debt weight is 40%, the break point is ₹100 crore of total capital.

How to solve Cost of Capital Fundamentals and WACC Review questions

Use this order for any WACC or marginal cost of capital item. It keeps you from mixing up inputs that the vignette often offers as distractors.

1Read the question first, then scan the vignette and exhibits for the target capital structure, market values, yields, betas, tax rate and any break-point data.
2Decide the weights. Use the stated target first. If none, use current market values (price × shares, market value of debt). Ignore book values unless told to use them.
3Convert any ratio given to weights. D/E of 0.5 gives wd = 0.5 ÷ 1.5 = 33.3% and we = 66.7%.
4Estimate each component cost: debt from current market yield, preferred from dividend ÷ price, equity from CAPM or another stated model.
5Tax-adjust debt only: rd × (1 − t).
6Multiply each cost by its weight and sum to get WACC.
7For marginal cost of capital, find break points, then compute WACC within each range using the costs that apply there.
8Match the rate to the project: use WACC only for average-risk projects financed at the target mix. Otherwise adjust for project risk.

Quickest way: Weights first, tax on debt only, then sum

When to use it: Use when the vignette gives clean component costs and a target mix and you have about two minutes.

Write the three weights on your scratch pad and check they sum to 100%.
Compute after-tax debt cost in one line.
Multiply and add using decimals, such as 0.40 × 4.2% = 1.68%.
Check the answer lies between the lowest and highest component cost. If not, you made an arithmetic or weighting error.
Eliminate options that equal the pre-tax WACC or that use book weights.

Common mistakes in Cost of Capital Fundamentals and WACC Review

Using book-value weights from the balance sheet
Balance sheet numbers are easy to find in an exhibit and look official.
Fix: Use target weights, or current market values. Book values are correct only if the question says so.
Forgetting to apply (1 − t) to the cost of debt
Students memorise the equity formula and treat debt the same way.
Fix: Apply the tax shield to debt only. Preferred dividends and equity returns get no tax adjustment.
Using the coupon rate as the cost of debt
The coupon is stated clearly in the vignette.
Fix: Use the current yield to maturity or the rate at which the firm could borrow now, because that is the cost of new debt.
Using the current structure when a target is given
Current market values are calculated in the exhibit and feel more concrete.
Fix: If a target structure is stated, it overrides the current mix for WACC.
Applying the firm's WACC to every project
WACC feels like the one hurdle rate.
Fix: Use WACC only when project risk matches the firm's average. A riskier project needs a higher rate, and the marginal cost applies to new funds.
Computing the break point by dividing by the wrong weight
Students confuse the amount of the component with total capital.
Fix: Break point = component amount at the cost change ÷ that component's weight in the target mix.

Worked examples

Example 1

Vignette: Nordal Freight targets a capital structure of 30% debt, 10% preferred stock and 60% common equity. Its debt yields 6.0% to maturity (coupon 4.5%). Preferred stock pays an annual dividend of 5.00 and trades at 62.50. The risk-free rate is 3.0%, the equity risk premium is 5.0%, beta is 1.20 and the tax rate is 25%. Q1: What is the after-tax cost of debt? Q2: What is the cost of equity? Q3: What is Nordal's WACC?

Show the solution

Q1: use the market yield, not the coupon. After-tax cost of debt = 6.0% × (1 − 0.25) = 4.50%.
Q2: re = 3.0% + 1.20 × 5.0% = 3.0% + 6.0% = 9.0%.
Preferred cost = 5.00 ÷ 62.50 = 8.0%.
Q3: WACC = 0.30 × 4.50% + 0.10 × 8.0% + 0.60 × 9.0%.
= 1.35% + 0.80% + 5.40% = 7.55%.

Answer: Q1: 4.50%. Q2: 9.0%. Q3: WACC = 7.55%.

Example 2

Vignette: Calder Energy has a target structure of 40% debt and 60% equity. Debt costs 5.0% after tax on the first 20 million raised and 6.0% after tax beyond that. Equity costs 10.0% up to 45 million of new equity and 12.0% beyond that. Q1: What is the break point for debt? Q2: What is the break point for equity? Q3: What is the marginal cost of capital for total new capital of 60 million?

Show the solution

Q1: debt break point = 20 million ÷ 0.40 = 50 million of total capital.
Q2: equity break point = 45 million ÷ 0.60 = 75 million of total capital.
Q3: 60 million lies above the debt break point of 50 million but below the equity break point of 75 million.
So debt costs 6.0% and equity costs 10.0% in this range.
MCC = 0.40 × 6.0% + 0.60 × 10.0% = 2.40% + 6.00% = 8.40%.

Answer: Q1: 50 million. Q2: 75 million. Q3: MCC = 8.40%.

Exam tips

Read for the word target. If the vignette states a target structure, use it, even when an exhibit shows different current weights.
Expect distractor inputs: coupon rate, book values, pre-tax cost and historical returns. Pick the market-based, forward-looking ones.
For marginal cost questions, sort the break points from lowest to highest and pick the range that contains the capital amount asked about.
Judgement questions ask when WACC is appropriate for a project. Answer by comparing project risk and financing mix with the firm's average.
There is no penalty for wrong answers, so never leave a question blank.

Cost of Capital Fundamentals and WACC Review in other exams

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

Cost of Capital Fundamentals and WACC Review: frequently asked questions

What is the WACC formula for CFA Level II?

WACC = wd × rd × (1 − t) + wp × rp + we × re. The weights are target market-value proportions that sum to 1. Only the cost of debt is adjusted for tax.

Should I use target weights or current weights in WACC?

Use the target capital structure when the question gives one. If none is given, use current market-value weights or the industry average if the firm is moving toward it. Do not use book values unless instructed.

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

WACC is the average cost of the firm's financing at the target mix. The marginal cost of capital is the cost of the next unit of new capital and can step up at break points. For a new project, the relevant rate is the marginal cost at the size and risk of the funding.

How do I find a break point for the marginal cost of capital?

Divide the amount of a component that can be raised at the lower cost by that component's weight in the target structure. The result is the total capital at which that component's cost changes.