🏢 Corporate Issuers

WACC Formula — Weighted Average Cost of Capital Explained

How to calculate WACC: cost of equity, cost of debt, and capital structure weights. Weighted average cost of capital formula with examples.

Key Concepts

WACC

Weighted average cost of capital = w<sub>d</sub>r<sub>d</sub>(1-t) + w<sub>e</sub>r<sub>e</sub>. Blended cost of debt and equity financing.

MM Proposition I (no taxes)

Capital structure is irrelevant to firm value in perfect markets. V<sub>L</sub> = V<sub>U</sub>.

MM Proposition II (no taxes)

Cost of equity increases linearly with leverage: r<sub>e</sub> = r<sub>0</sub> + (r<sub>0</sub> - r<sub>d</sub>) × D/E.

MM with Taxes

Debt creates a tax shield: V<sub>L</sub> = V<sub>U</sub> + t×D. More debt increases firm value through interest tax deductibility.

Optimal Capital Structure

Balances tax benefits of debt against costs of financial distress. Minimizes WACC, maximizes firm value.

Pecking Order Theory

Firms prefer: 1) Internal financing, 2) Debt, 3) Equity. Due to information asymmetry — issuing equity signals overvaluation.

Formulas

From this module

WACC

WACC = wd × rd × (1-t) + we × re

Where: w = weight, r<sub>d</sub> = cost of debt, r<sub>e</sub> = cost of equity, t = tax rate

MM Prop I (with taxes)

VL = VU + t × D

Where: Tax shield increases levered firm value

MM Prop II (no taxes)

re = r0 + (r0 - rd) × D/E

Where: r<sub>0</sub> = unlevered cost of equity

Cost of Equity (CAPM)

re = rf + β × (rm - rf)

Where: r<sub>f</sub> = risk-free rate, β = beta, r<sub>m</sub> - r<sub>f</sub> = market risk premium

Master Formula Sheet -- Corporate Issuers

NPV

NPV = Σ[CFₜ / (1+r)ᵗ] - Initial Investment

Accept if NPV > 0

IRR

Rate where NPV = 0

Accept if IRR > required return

Payback Period

Time to recover initial investment

Ignores TVM and post-payback CFs

WACC

WACC = w_d × r_d(1-t) + w_e × r_e

After-tax weighted average cost

Cost of Equity (CAPM)

r_e = Rᶠ + β(R_m - Rᶠ)

Risk-free + equity risk premium

DOL

DOL = %ΔOI / %ΔREV = (Rev - VC) / (Rev - VC - FC)

Operating leverage sensitivity

DFL

DFL = %ΔEPS / %ΔOI = OI / (OI - Interest)

Financial leverage sensitivity

DTL

DTL = DOL × DFL

Total leverage effect

Breakeven

Q = FC / (P - VC)

Units to cover fixed costs

Decision Frameworks

More debt or more equity?

Use when:

  • More debt: stable cash flows, high tax rate, low financial distress costs (e.g., utilities)
  • More equity: volatile cash flows, high growth, significant intangible assets (e.g., tech)

Avoid when:

  • Too much debt for cyclical businesses — financial distress costs dominate

Test Your Understanding

Given: D/V=30%, E/V=70%, r<sub>d</sub>=6%, r<sub>e</sub>=14%, tax=25%. WACC is closest to:

Master this topic

Full cheat sheet, flashcards, mind map, and quiz for Capital Structure.

Master Formula Sheet

All 80+ CFA Level 1 formulas in one searchable reference page.

Ready to study WACC Formula — Weighted Average Cost of Capital Explained?

Jump into the full module with cheat sheets, flashcards, mind maps, and practice questions.

Start Studying

No signup required. Create an account anytime to save progress.