{"id":45878,"date":"2023-08-23T05:56:20","date_gmt":"2023-08-23T05:56:20","guid":{"rendered":"https:\/\/analystprep.com\/cfa-level-1-exam\/?p=45878"},"modified":"2026-02-13T19:22:04","modified_gmt":"2026-02-13T19:22:04","slug":"weighted-average-cost-of-capital","status":"publish","type":"post","link":"https:\/\/analystprep.com\/cfa-level-1-exam\/uncategorized\/weighted-average-cost-of-capital\/","title":{"rendered":"Weighted-Average Cost of Capital"},"content":{"rendered":"\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"A company has the following capital structure: 35% equity, 15% preferred stock, and 50% debt. If its marginal cost of equity is 10%, the cost of preferred stock is 7%, and the before-tax cost of debt is 8%, with a marginal tax rate of 30%, the WACC of the company is closest to:\",\n    \"text\": \"A company has the following capital structure: 35% equity, 15% preferred stock, and 50% debt. If its marginal cost of equity is 10%, the cost of preferred stock is 7%, and the before-tax cost of debt is 8%, with a marginal tax rate of 30%, the WACC of the company is closest to:\\n\\nA. 5.84%.\\n\\nB. 6.65%.\\n\\nC. 7.35%.\",\n    \"answerCount\": 1,\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"The correct answer is C.\"\n    }\n  }\n}\n<\/script>\n\n\n\n\n<p>\/\/www.youtube.com\/embed\/PFbiNV1640k<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Cost of Capital<\/h2>\n\n\n\n<p>The cost of capital is the rate of return the suppliers of capital (shareholders and debtholders) require as compensation for their capital contribution. In other words, the cost of capital can be seen as the opportunity cost of funds for the suppliers of the capital.<\/p>\n\n\n\n<p>The cost of capital is composed of the cost of debt and the cost of equity. The cost of debt is riskier than the cost of equity and is sometimes secured with collateral. As such, debtholders have lower required rates of return than equity holders.<\/p>\n\n\n\n<!-- TOP CTA \u2013 Full Width Outline Button -->\n<div style=\"margin:24px 0;\">\n  <a href=\"https:\/\/analystprep.com\/free-trial\/\"\n     target=\"_blank\"\n     rel=\"noopener noreferrer\"\n     style=\"\n       display:block;\n       width:100%;\n       padding:13px 0;\n       border:2px solid #3b6fd8;\n       border-radius:50px;\n       font-size:17px;\n       font-weight:500;\n       text-align:center;\n       text-decoration:none;\n       color:#3b6fd8;\n       background-color:#f4f6f9;\n       box-sizing:border-box;\n     \">\n     Practice WACC questions with free trial access.\n  <\/a>\n<\/div>\n\n\n<h2>Weighted Average Cost of Capital<\/h2>\n<p>The weighted average cost of capital (WACC) is the company&#8217;s capital cost, which is the rate of return that investors demand. It is usually estimated by computing the marginal cost of each of the various sources of capital for a company and then taking a weighted average of these costs.<\/p>\n<p>The formula for the WACC is:<\/p>\n<p>$$ \\begin{align*} WACC &amp; =\\left[\\left(1-\\text{Tax rate}\\right)\\times \\text{Pre-tax cost of debt} \\times \\text{Weighting of debt}\\right] \\\\ &amp; +(\\text{Cost of equity}\\times \\text{Weighing of equity}) \\end{align*} $$<\/p>\n<p>From the formula above:<\/p>\n<ul>\n<li>From an issuer&#8217;s perspective, the cost of debt is the required rate of return on debt financing. It is usually an interest in the existing unsecured loans or bonds. However, a forward-looking measure of the cost of debt can be obtained by checking the rates on companies that recently borrowed. Lastly, if the interest expense is deductible, we decrease the nominal tax rate by \\(\\left(1-\\text{Tax rate}\\right)\\).<\/li>\n<li>The weightings of debt and equity can be based on market value proportions or the target weights given by management, which are based on book value proportions. Market values are commonly used because book values reflect historical values, while market values reflect current market prices.<\/li>\n<li>From the issuer&#8217;s perspective, the cost of equity is the return that equity investors expect. It is higher than the cost of debt and is not tax-deductible.<\/li>\n<\/ul>\n<p><strong>Example: Calculating the WACC<\/strong><\/p>\n<p>Assume that company XYZ has the following capital structure: 25% equity, 10% preferred stock, and 65% debt. Its marginal cost of equity is 12%, while its marginal cost of preferred stock is 9%. Lastly, its before-tax cost of debt is 7%. If the marginal tax rate is 35%, what is the WACC of company XYZ?<\/p>\n<p>In this example, weighting of debt = 65%, cost of debt = 7%, tax rate = 35%, weighting of equity = 25%, and cost of equity= 12%.<\/p>\n<p>And we know that,<\/p>\n<p>$$ \\begin{align*} WACC &amp; =\\left[\\left(1-\\text{Tax rate}\\right)\\times \\text{Pre-tax cost of debt} \\times \\text{Weighting of debt}\\right]\u00a0 +\\\\ &amp;(\\text{Cost of Preferred Shares}\\times \\text{Weighing of Preferred Shares}+\\\\ &amp;(\\text{Cost of equity}\\times \\text{Weighing of equity}) \\end{align*} $$<\/p>\n<p>Therefore<\/p>\n<p>$$\\text{WACC} = \\left[ (1 &#8211; 0.35) \\times (0.07 \\times 0.65) \\right] + (0.12 \\times 0.25) + (0.10 \\times 0.09) = 0.02957 + 0.03 + 0.009 = 0.0685 \\text{ or } 6.85\\%$$<\/p>\n<blockquote>\n<h2>Question<\/h2>\n<p>A company has the following capital structure: 35% equity, 15% preferred stock, and 50% debt. If its marginal cost of equity is 10%, the cost of preferred stock is 7%, and the before-tax cost of debt is 8%, with a marginal tax rate of 30%, the WACC of the company is <em>closest to<\/em>:<\/p>\n<ol type=\"A\">\n<li>5.84%.<\/li>\n<li>6.65%.<\/li>\n<li>7.35%.<\/li>\n<\/ol>\n<p><strong>Solution<\/strong><\/p>\n<p><strong>The correct answer is C<\/strong>.<\/p>\n<p>$$ \\begin{align*} WACC &amp;= \\big[(1-\\text{Tax rate}) \\times \\text{Pre-tax cost of debt} \\times \\text{Weight of debt}\\big] \\\\ &amp;\\quad + (\\text{Cost of equity} \\times \\text{Weight of equity}) \\\\ &amp;\\quad + (\\text{Cost of preferred stock} \\times \\text{Weight of preferred stock}) \\\\ &amp;= \\big[(1-0.3) \\times 0.08 \\times 0.50\\big] + (0.10 \\times 0.35) + (0.07 \\times 0.15) \\\\ &amp;= (0.7 \\times 0.04) + 0.035 + 0.0105 \\\\ &amp;= 0.028 + 0.035 + 0.0105 \\\\ &amp;= 0.0735 \\text{ or } 7.35\\%. \\end{align*} $$<\/p>\n<\/blockquote>\n\n\n<!-- BOTTOM CTA \u2013 Refined Version -->\n<div style=\"text-align:center; background-color:#f4f6f9; padding:32px 20px; border-radius:12px; margin-top:40px;\">\n\n  <a href=\"https:\/\/analystprep.com\/free-trial\/\"\n     target=\"_blank\"\n     rel=\"noopener noreferrer\"\n     style=\"\n       display:inline-block;\n       padding:13px 30px;\n       background-color:#3b6fd8;\n       color:#ffffff;\n       border-radius:50px;\n       font-size:15.5px;\n       font-weight:600;\n       text-decoration:none;\n       margin-bottom:16px;\n     \">\n     Start Free Trial\n  <\/a>\n\n  <p style=\"max-width:680px; margin:0 auto; font-size:15.5px; line-height:1.6; color:#333;\">\n    Strengthen your CFA Level I corporate finance skills with exam-style weighted average cost of capital problems, structured explanations, and timed practice designed to improve calculation accuracy.\n  <\/p>\n\n<\/div>\n","protected":false},"excerpt":{"rendered":"<p>\/\/www.youtube.com\/embed\/PFbiNV1640k Cost of Capital The cost of capital is the rate of return the suppliers of capital (shareholders and debtholders) require as compensation for their capital contribution. In other words, the cost of capital can be seen as the opportunity&#8230;<\/p>\n","protected":false},"author":7,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[1],"tags":[],"class_list":["post-45878","post","type-post","status-publish","format-standard","hentry","category-uncategorized","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Weighted Average Cost of Capital | CFA I<\/title>\n<meta name=\"description\" content=\"Learn the weighted average cost of capital (WACC), including its definition, formula, and how it is applied in valuation and capital budgeting.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" 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