CFA Program Level I

WACC: which weights, cost of debt and tax rate? CFA Level I

WACC is the cost of the debt and equity capital a company uses to finance its assets, weighted by each source's share. Use the return lenders require now (not the old coupon), the marginal tax rate, and the long-term target capital structure, which may differ from today's mix.

The formula

WACC = wd x rd x (1 - t) + we x re, where wd and we are the weights of debt and equity, rd is the before-tax cost of debt, re is the cost of equity and t is the tax rate. Add a preferred stock term if the company has preferred shares.

The cost of debt is after tax because interest is deductible. The cost of equity is the return equity investors require to own the company.

A company uses its WACC to evaluate capital investments. Analysts use it as an input when valuing the company.

Choosing the inputs

Cost of debt: use the return debt investors currently require, such as the yield to maturity on the company's outstanding bonds. The coupon set years ago reflects past market conditions.

Tax rate: use the marginal tax rate, the rate paid on an extra unit of income. It can differ from the average or effective rate, for example after tax credits.

Weights: use the long-term target capital structure. That target might or might not be the current capital structure. If the board has set a target mix it will hold, use it.

Worked example

A company targets 40% debt and 60% equity. Its bonds yield 6.0%, its marginal tax rate is 25%, and its cost of equity is 10.0%.

After-tax cost of debt = 6.0% x (1 - 0.25) = 4.5%. Debt term = 0.40 x 4.5% = 1.8%. Equity term = 0.60 x 10.0% = 6.0%.

WACC = 1.8% + 6.0% = 7.8%. Using a 4.0% historical coupon, a 17% effective tax rate or the current 20% debt weight instead would each give a different and less appropriate figure.

Where the exam catches people

Believing the cost of debt is the bond's coupon: it is the yield lenders require today.
Believing the effective tax rate goes in WACC: the marginal rate is used.
Believing the weights must be today's mix: WACC uses the long-term target capital structure.
Believing the cost of debt enters WACC before tax: it is multiplied by (1 - marginal tax rate).

Written from CFA Institute's documentation

Try 3 questions on this

Pick an answer to see why each option is right or wrong.

Ellery Corp issued 10-year bonds at par with a 4.0% coupon six years ago. Market rates have since risen, and the bonds now trade at a yield to maturity of 6.5%. In estimating Ellery's weighted-average cost of capital today, the before-tax cost of debt is most appropriately based on:
Right. In the game that’s Renown for your Corporate Finance building.
Not that one: B is right. In the game your Corporate Finance building would lose a little Renown, and this question would come back later.
Your answerA.The 5.25% average of the two ratesAveraging the 4.0% coupon and the 6.5% yield to get 5.25% mixes a historical contract rate with a current market rate. The cost of debt is the current required return alone.The answerB.The 6.5% return lenders currently requireWACC measures the cost of the capital financing the company now. The cost of debt rests on the return debt investors currently require to finance the company, which for Ellery is the 6.5% yield on its outstanding bonds, before the tax adjustment.Your answerC.The 4.0% coupon fixed at issuanceThe 4.0% coupon is what Ellery agreed to pay when rates were lower. A lender today would demand 6.5%, so the coupon understates the cost of financing the company with debt now.
Show the full explanation and doc quotes
The 4.0% coupon reflects market conditions six years ago.
Written from www.cfainstitute.org/insights/professional-learning/refresher-readings/2026/cost-capital-advanced-topics
Pell Industries pays tax at 25% on each additional unit of taxable income, but research credits bring its total tax expense down to 17% of pretax income. In computing Pell's after-tax cost of debt for its weighted-average cost of capital, the tax rate an analyst should use is most appropriately:
Right. In the game that’s Renown for your Corporate Finance building.
Not that one: C is right. In the game your Corporate Finance building would lose a little Renown, and this question would come back later.
Your answerA.21%, a blend of the two ratesA 21% blend of the 17% effective and 25% marginal rates has no basis. The after-tax cost of debt uses the marginal rate.Your answerB.17%, its effective tax rateThe 17% is Pell's effective rate, total tax expense over pretax income, pulled down by credits. The after-tax cost of debt uses the marginal rate, 25%, which can differ from the effective rate.The answerC.25%, its marginal tax rateThe cost of debt in WACC is after tax, and the rate to apply is the company's marginal tax rate, which has to be estimated and can differ from its average or effective rate.
Show the full explanation and doc quotes
Pell's marginal rate, paid on each additional unit of income, is 25%; the 17% is its effective rate after credits.
Written from www.cfainstitute.org/insights/professional-learning/refresher-readings/2026/cost-capital-advanced-topics
Lisner Chemicals is financed 20% with debt and 80% with equity at market value. Its board has adopted a policy of moving to 40% debt and holding that mix from then on. In computing the WACC used to evaluate Lisner's new capital investments, the debt weight is most appropriately:
Right. In the game that’s Renown for your Corporate Finance building.
Not that one: C is right. In the game your Corporate Finance building would lose a little Renown, and this question would come back later.
Your answerA.20%, the current weightTwenty percent describes Lisner today, but the board has committed to moving away from it. WACC for new investments rests on the long-term target structure, which here is 40% debt.Your answerB.30%, the average of the twoThirty percent is an average of the current and planned weights, a mix Lisner neither has now nor intends to keep. The weight comes from the long-term target structure: 40%.The answerC.40%, the planned weightWACC is the cost of the debt and equity capital a company uses to finance its assets, and the company uses it to evaluate capital investments.
Show the full explanation and doc quotes
Computing it requires assuming a long-term target capital structure, and that target need not match the current mix. Lisner's board has set 40% debt as the mix it will hold, so that is the weight.
Written from www.cfainstitute.org/insights/professional-learning/refresher-readings/2026/cost-capital-advanced-topics