Level 1 CFA® Exam:
Weighted Average Cost of Capital (WACC)
WACC – Definition & Formula for CFA Examstar content check off when done
The cost of capital is the rate of return that bondholders or lenders, on the one hand, and owners of the company, on the other hand, obtain as compensation for their contribution of capital.
A company typically has different sources of capital at its disposal. They include:
- debt, and
- instruments that share characteristics of both, e.g. preferred stock.
Each source is a component cost of capital.
The most common way to calculate the cost of capital is to use the weighted average cost of capital (WACC). The WACC is also referred to as the marginal cost of capital (MCC) because it is the cost that a company incurs for additional capital.
To calculate the WACC in your level 1 CFA exam, use this formula:
Assume that Cherry, Inc. has the following capital structure: 50% common stock, 20% preferred stock, and 30% debt. The company’s before-tax cost of debt is 5%, its cost of preferred stock is 7% and its cost of common stock is 9%. Assuming that tax rate equals 20%, what is the company's weighted average cost of capital?
CFA Exam: Effect of Taxes on Cost of Capitalstar content check off when done
As you can see, in the WACC formula we adjust the expected before-tax cost on new debt financing by a factor of \((1-t)\). Why is it so?
Because we deal with a tax shield. Interest lowers the taxable income, which results in a lowered tax. Let's see the following example:
Electronic Rewards Inc. incurred a USD 100,000 debt with an interest of USD 10,000 a year. Let's assume that the tax rate is 20% and the company reached an EBIT of USD 1,000,000.
Calculate the taxes in two cases:
- in the first hypothesized case, the company does not have to pay the interest of USD 10,000,
- in the second, the company has to pay USD 10,000 in interest.
Also, please compute the tax shield.
Level 1 CFA Exam Takeaways: Weighted Average Cost of Capital (WACC)star content check off when done
- The weighted average cost of capital (WACC) is the most common way to calculate the cost of capital.
- When computing the cost of capital the 3 main capital sources should be considered: debt, preferred stock, and common stock.
- Because generally debt is senior to preferred stocks and common stocks are subordinate to preferred stocks in terms of claim to the company’s assets, the cost of debt is usually the lowest and the cost of common stock is the highest for the company.
- Because of the tax shield, the before-tax cost of debt should be multiplied by \((1-t)\) to arrive at the after-tax cost of debt.
- The weights of particular sources of financing depend on the target capital structure.