Corporate Accounting and Financial Management · Operational Approach to Financial Decision

Weighted Average Cost of Capital (WACC) Formula and Examples

Updated 11 October 2026 · Fact-checked

WACC is the overall cost of a firm's long-term funds. You multiply the cost of each source (equity, preference, debt, retained earnings) by its weight in the capital structure, then add the results. Weights can be book value or market value. Use after-tax cost for debt.

Understand Weighted Average Cost of Capital (WACC)

A company raises money from different sources. Each source has a different cost. Debt is usually cheaper than equity. Equity holders want a higher return because they carry more risk.

So you cannot judge a project against just one cost. You need one blended figure for the whole pool of funds. That figure is the Weighted Average Cost of Capital (WACC). It is the minimum return a firm must earn on its investments to keep its investors satisfied.

The weights show how much of the total capital comes from each source. Book value weights use the figures in the balance sheet. They are simple and stable. Market value weights use current market prices of shares and debentures. They show the true present worth of each source, so most textbooks prefer them in theory. In an exam, use whichever the question gives or asks for. If it gives both, follow the instruction.

Marginal cost of capital (MCC) is different. It is the cost of raising one more rupee of new capital. WACC looks at the existing mix. MCC looks at the next block of funds, at today's costs and the proposed financing mix. When a firm raises a large amount, costs often rise, so MCC can be higher than the current WACC.

Remember the direction of use: WACC is the discount rate for projects of average risk, and MCC guides the next financing decision.

Key rules to remember

WACC: WACC (Ko) = Σ (Cost of each source × Weight of that source) = Σ (Ki × Wi); Weights must add up to 1 (or 100%). Use the same weighting basis for all sources.
Weight of a source: Wi = Value of that source ÷ Total value of all long-term sources; Value is book value or market value, as the question needs.
After-tax cost of debt (irredeemable): Kd = [I × (1 − t)] ÷ NP, or Kd = Interest rate × (1 − t) if issued at par; NP is net proceeds. t is the tax rate. Interest saves tax, so use the after-tax figure.
Cost of preference capital (irredeemable): Kp = Preference dividend ÷ Net proceeds; No tax adjustment, because dividend is not tax deductible.
Cost of equity (dividend growth approach): Ke = (D1 ÷ P0) + g; D1 = D0 × (1 + g). P0 is current market price or net proceeds.
Cost of equity (CAPM): Ke = Rf + β × (Rm − Rf); Use when risk-free rate, beta and market return are given.
Cost of retained earnings: Kr = Ke (ignoring issue costs and personal tax); Use Ke unless the question gives an adjustment.
Marginal cost of capital: MCC = Σ (Cost of each new source × Proportion of new funds from that source); Uses the cost of new funds and the proposed mix, not the existing balance sheet mix.

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

Follow this order for any WACC or marginal cost question. It keeps the working neat and earns method marks.

1Read the question and note the weighting basis asked: book value, market value, or target (proposed) mix.
2List all long-term sources: equity share capital, reserves and retained earnings, preference capital, debentures and term loans. Leave out current liabilities unless told to include them.
3Calculate the cost of each source using the correct formula. Apply (1 − t) to debt only.
4Fix the value of each source on the chosen basis. For market value, use market price × number of shares or debentures.
5Find each weight by dividing each value by the total.
6Multiply cost by weight for each source and add them to get WACC.
7For marginal cost, repeat steps 3 to 6 using the cost of new funds and the proposed proportions.
8State the answer in percent, and add one line on what it means if the question asks for interpretation.

Quickest way: Table method with value × cost

When to use it: Use when the exam gives several sources and you must finish in a few minutes.

Draw a table with columns: Source, Amount, Cost (%), Weight or Total cost.
Skip the weight column. Multiply Amount × Cost directly to get the rupee cost of each source.
Add the Amount column and the rupee cost column.
Divide total rupee cost by total amount, then × 100. This equals WACC.
This avoids rounding errors from weights and saves one step.

Common mistakes in Weighted Average Cost of Capital (WACC)

Using the pre-tax cost of debt in WACC.
Students copy the coupon rate and forget that interest is tax deductible.
Fix: Always multiply the debt cost by (1 − t). Do not adjust preference or equity.
Mixing book value and market value in the same calculation.
Some figures come from the balance sheet and others from market prices, so students pick whichever is handy.
Fix: Pick one basis for all sources. If market value of a source is not given, state your assumption clearly.
Treating the market price of debentures as face value.
Students overlook that debentures may trade above or below par.
Fix: For market value weights, use the quoted price × number of debentures. Use face value only for book weights.
Forgetting retained earnings in the capital mix.
Students count only share capital and leave out reserves.
Fix: Include reserves and surplus as a source with cost equal to Ke, unless the question says otherwise.
Confusing WACC with marginal cost of capital.
Both give a blended percentage, so they look alike.
Fix: WACC uses the existing capital structure. Marginal cost uses the cost and mix of new funds. Check which one the question asks for.
Using D0 instead of D1 in the cost of equity.
The question gives the dividend just paid, and students plug it in directly.
Fix: If the dividend is already paid, compute D1 = D0 × (1 + g) before using Ke = D1 ÷ P0 + g.

Worked examples

Example 1

Sharma Textiles Ltd has the following capital structure: Equity share capital ₹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%. Preference shares and debentures are issued at par. Tax rate is 25%. Calculate WACC using book value weights.

Show the solution

Cost of debt = 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.
Equity: 40,00,000 × 15% = ₹6,00,000.
Retained earnings: 20,00,000 × 15% = ₹3,00,000.
Preference: 10,00,000 × 10% = ₹1,00,000.
Debentures: 30,00,000 × 9% = ₹2,70,000.
Total cost = 6,00,000 + 3,00,000 + 1,00,000 + 2,70,000 = ₹12,70,000.
WACC = 12,70,000 ÷ 1,00,00,000 × 100 = 12.7%.

Answer: WACC on book value weights = 12.7%.

Example 2

Mehta Industries Ltd has 1,00,000 equity shares of ₹10 each, currently quoted at ₹30. It has 10,000 debentures of ₹100 each, 10% coupon, issued at par and currently quoted at par. Cost of equity is 16%. Tax rate is 30%. Compute WACC using market value weights. Then, if the firm raises ₹10,00,000 of new funds, half from equity at a cost of 18% and half from debt at a pre-tax cost of 12%, compute the marginal cost of capital.

Show the solution

Market value of equity = 1,00,000 × ₹30 = ₹30,00,000.
Market value of debentures = 10,000 × ₹100 = ₹10,00,000.
Total market value = ₹40,00,000.
Weights: equity = 30 ÷ 40 = 0.75; debt = 10 ÷ 40 = 0.25.
After-tax cost of debt = 10% × (1 − 0.30) = 7%.
WACC = (0.75 × 16%) + (0.25 × 7%) = 12% + 1.75% = 13.75%.
For marginal cost: new debt after-tax cost = 12% × (1 − 0.30) = 8.4%.
Proportions of new funds: equity 50%, debt 50%.
MCC = (0.50 × 18%) + (0.50 × 8.4%) = 9% + 4.2% = 13.2%.

Answer: WACC on market value weights = 13.75%. Marginal cost of capital on the new funds = 13.2%.

Exam tips

Read whether the question asks for book value, market value or target weights. Writing the basis at the top of your answer shows the examiner you know the difference.
Show a clear table with source, amount, cost and weighted cost. Even if one cost is wrong, you still earn method marks for the rest.
Calculate each individual cost first, since the numerical often hides them in raw data such as issue price, flotation cost or growth rate.
If the question asks for the difference between WACC and marginal cost of capital, give the definition, the basis of weights and the use of each in two or three crisp points.
Keep percentages to two decimal places unless told otherwise, and always state the final answer with the % sign.

Practice questions from Operational Approach to Financial Decision

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 and market value weights in WACC?

Book value weights use the amounts shown in the balance sheet. Market value weights use current market prices of shares and debentures. Market weights reflect present worth, while book weights are easier to compute and more stable.

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

WACC is the average cost of all existing long-term funds based on the current capital mix. Marginal cost of capital is the cost of raising an additional rupee of new funds, using the cost and mix of those new funds. It guides the next financing decision.

Why is only the cost of debt adjusted for tax?

Interest on debt is a tax-deductible expense, so it reduces the firm's tax bill. Dividends on preference and equity shares are paid out of profit after tax, so no tax saving arises.

Should I include retained earnings in WACC?

Yes. Retained earnings belong to equity holders and have an opportunity cost. Treat them as a separate source with a cost equal to the cost of equity, unless the question gives a different adjustment.