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Financial Management and Business Data Analytics · Cost of Capital

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

Updated 10 October 2026 · Fact-checked

WACC is the average cost of a firm's long-term funds, with each source weighted by its share in the total capital. Find the after-tax cost of each source, choose book value or market value weights, multiply each cost by its weight, and add the results. Market value weights are preferred in theory.

Understand Weighted Average Cost of Capital (WACC)

A company raises money from equity, preference shares, debentures and loans. Each source has a different cost. Lenders want interest, preference holders want a fixed dividend and equity holders want returns for bearing the most risk. So the firm has no single 'cost of capital' until you combine them.

Weighted Average Cost of Capital (WACC) does that. It is the overall cost of the firm's capital, and every source counts in proportion to how much of the total it supplies. A source that supplies 60% of the funds affects WACC more than one that supplies 10%.

WACC matters because it is the minimum return a project must earn to keep the firm's investors satisfied. In capital budgeting it is commonly used as the discount rate for projects with average risk. A project that earns more than WACC adds value. One that earns less destroys it.

The weights can be taken in two ways. Book value weights use the amounts in the balance sheet. They are easy to get and stable, but they show historical figures. Market value weights use the current market price of each security. They show what investors would pay today, so they are theoretically better. They need market data and change whenever prices change.

A third idea is target or marginal weights. These use the capital structure the firm plans to keep while raising new funds. They suit decisions about fresh financing.

Key rules to remember

WACC
WACC = Σ (Wi × Ki) = (E × Ke + P × Kp + D × Kd after tax) ÷ (E + P + D)
Wi is the weight of each source and Ki its cost. The weights must add up to 1 (or 100%). Use the same method, book or market, for all sources.
Weight of a source
Weight = Value of that source ÷ Total value of all sources
Use book values or market values as the question directs. Do not mix the two in one calculation.
After-tax cost of debt
Kd (after tax) = Interest rate × (1 − tax rate)
Interest is tax-deductible, so debt cost is taken after tax. Preference dividend and equity return are not tax-deductible.
Cost of equity (CAPM)
Ke = Rf + β × (Rm − Rf)
Use when the question gives a risk-free rate, beta and market return or premium.
Cost of equity (dividend growth)
Ke = D1 ÷ P0 + g
D1 is next year's expected dividend, not the dividend just paid. If D0 is given, D1 = D0 × (1 + g).
Cost of irredeemable preference shares
Kp = Preference dividend ÷ Net proceeds (or market price)
For redeemable shares, use the yield-to-maturity or approximation method that the question requires.

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

Use this order for any WACC question. It keeps your layout clean and earns step marks even if one figure goes wrong.

  1. 1List every source of long-term capital with its amount: equity share capital, reserves, preference shares, debentures and term loans. Leave out current liabilities unless the question includes them.
  2. 2Note whether the question asks for book value weights, market value weights or target weights. If it gives both book and market data, use only the basis asked.
  3. 3Compute the cost of each source. Adjust debt for tax. Use CAPM or the dividend growth formula for equity, as the data allows.
  4. 4Decide the value of each source on the chosen basis. For book value, add reserves and surplus to equity. For market value, use number of shares × market price, and the market value of debentures and preference shares.
  5. 5Find the weight of each source by dividing its value by the total. Check that the weights add up to 1.
  6. 6Multiply each cost by its weight in a table with columns: source, amount, weight, cost, weighted cost.
  7. 7Add the weighted costs to get WACC. State it as a percentage, usually to two decimals.
  8. 8If asked, comment on the result: compare it with project return or say how the answer would change under the other weighting basis.

Quickest way: Amount × cost shortcut

When to use it: Use when the total is a round figure and you only need the final WACC, not the weights.

  1. Skip the weight column. Multiply each source's amount by its cost to get the annual cost in rupees.
  2. Add all these annual costs.
  3. Divide the sum by the total capital. The result is WACC.
  4. Sense-check: WACC must lie between the lowest and highest individual cost. If it does not, recheck.

Common mistakes in Weighted Average Cost of Capital (WACC)

  • Using pre-tax cost of debt in WACC

    The interest rate is given in the question and students plug it straight in.

    Fix: Always write Kd × (1 − t) as a separate line before the table, unless the question says the cost is already after tax.

  • Leaving reserves out of equity in book value weights

    Students take only the equity share capital figure.

    Fix: Under book value weights, equity means share capital plus reserves and surplus. Retained earnings carry the cost of equity.

  • Mixing book and market values in one calculation

    The question gives face values for debentures and market prices for shares, and students use whatever is nearest.

    Fix: Choose one basis and convert every source to it. If market value of a source is not given for a market-weight question, state your assumption clearly.

  • Using D0 instead of D1 in the dividend growth formula

    The question gives the dividend just paid and students divide it by the price.

    Fix: Check the wording. If it says 'just paid' or 'current dividend', compute D1 = D0 × (1 + g) first.

  • Weights that do not add up to 100%

    Rounding errors or one source left out of the total.

    Fix: Add the weights before multiplying. Keep fractions or three decimals until the final answer.

  • Taking the number of shares times face value as market value

    Face value is the first figure in the data.

    Fix: Market value of equity = number of shares × current market price per share, not face value.

Worked examples

Example 1

Prestige Components Ltd has the following capital structure: Equity share capital ₹40,00,000; Reserves and surplus ₹20,00,000; 12% Preference share capital ₹10,00,000; 10% Debentures ₹30,00,000. The cost of equity is 15%. Preference shares and debentures are issued and redeemable at par, with no issue cost. The tax rate is 25%. Calculate WACC using book value weights.

Show the solution
  1. Total capital = 40,00,000 + 20,00,000 + 10,00,000 + 30,00,000 = ₹1,00,00,000.
  2. Equity including reserves = 40,00,000 + 20,00,000 = ₹60,00,000. Weight = 0.60.
  3. Preference weight = 10,00,000 ÷ 1,00,00,000 = 0.10. Debenture weight = 30,00,000 ÷ 1,00,00,000 = 0.30.
  4. Cost of equity Ke = 15%. Cost of preference Kp = 12% (dividend ÷ par value).
  5. Cost of debt after tax = 10% × (1 − 0.25) = 7.5%.
  6. Weighted costs: equity 0.60 × 15 = 9.00%; preference 0.10 × 12 = 1.20%; debt 0.30 × 7.5 = 2.25%.
  7. WACC = 9.00 + 1.20 + 2.25 = 12.45%.

Answer: WACC on book value weights = 12.45%.

Example 2

Sundaram Textiles Ltd has 2,00,000 equity shares quoted at ₹150 each. It has 10% preference shares with a market value of ₹50,00,000 and a cost of 10%, and debentures with a market value of ₹1,00,00,000 whose pre-tax cost is 10%. The risk-free rate is 7%, the market return is 12% and the equity beta is 1.2. The tax rate is 30%. Calculate WACC using market value weights.

Show the solution
  1. Market value of equity = 2,00,000 × ₹150 = ₹3,00,00,000.
  2. Total market value = 3,00,00,000 + 50,00,000 + 1,00,00,000 = ₹4,50,00,000.
  3. Cost of equity by CAPM: Ke = 7 + 1.2 × (12 − 7) = 7 + 6 = 13%.
  4. Cost of debt after tax = 10% × (1 − 0.30) = 7%. Cost of preference = 10%.
  5. Weights: equity 300 ÷ 450 = 0.6667; preference 50 ÷ 450 = 0.1111; debt 100 ÷ 450 = 0.2222 (figures in ₹ lakh).
  6. Annual cost in ₹ lakh: equity 300 × 13% = 39.00; preference 50 × 10% = 5.00; debt 100 × 7% = 7.00. Total = 51.00.
  7. WACC = 51.00 ÷ 450 = 11.33% (approx.).

Answer: WACC on market value weights is about 11.33%.

Exam tips

  • Read the question for the weighting basis first. Many questions ask for both book and market WACC, so draw two tables and keep them separate.
  • Show the table with source, amount, weight, cost and weighted cost. Examiners award marks for each cost and weight even when the final figure is off.
  • Write the after-tax cost of debt as a visible working line. It is the most commonly missed step.
  • In MCQs, check the options for the pre-tax trap: one distractor usually comes from using the interest rate without tax adjustment. There is no negative marking, so always attempt every question.
  • When the question asks for comment, say that market weights reflect current investor values and book weights reflect historical accounting values, then link WACC to the project's discount rate.

Practice questions from Cost of Capital

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

What is the difference between book value weights and market value weights?

Book value weights use balance sheet amounts, including reserves in equity. Market value weights use current market prices of shares, debentures and preference shares. Market weights show present investor values and are theoretically better. Book weights are easier to find and more stable.

Which weights should I use if the question does not say?

Read the data given. If market prices are provided, use market value weights and state that choice. If only balance sheet figures are given, use book values. In either case, state your assumption in one line.

Do I include reserves in the WACC calculation?

Yes, under book value weights. Reserves and surplus belong to equity shareholders, so add them to equity share capital. Under market weights, the market value of equity already reflects them, so do not add reserves again.

Why is cost of debt taken after tax but equity and preference are not?

Interest on debt is deductible when computing taxable profit, so it saves tax. Dividends on equity and preference shares are paid out of profit after tax, so they give no tax saving. Only debt cost is adjusted by (1 − tax rate).