Questions: Weighted Average Cost of Capital (WACC)

Question 1

A firm is financed 60% by equity (cost of equity = 12%) and 40% by debt (pretax cost of debt = 6%), with a corporate tax rate of 25%. What is its WACC?

• A. 9.0%
• B. 9.6%
• C. 10.2%
• D. 8.4%

Answer: (A)

WACC = (0.60)(0.12) + (0.40)(0.06)(1 − 0.25) = 0.072 + (0.40)(0.045) = 0.072 + 0.018 = 0.090 = 9.0%. The key step is applying the (1−T_c) tax shield to the debt cost. Option B (9.6%) is the common error of ignoring the tax shield: (0.60)(0.12) + (0.40)(0.06) = 0.072 + 0.024 = 0.096. The tax deductibility of interest is not optional — it is the reason debt is cheaper than equity on an after-tax basis.

Question 2

Why is the debt cost in the WACC formula multiplied by (1 − T_c), but the equity cost is not?

• A. Debt is riskier than equity, so it must be discounted by the tax factor
• B. Interest payments on debt are tax-deductible, so the government effectively subsidizes part of the debt cost; equity dividends carry no such shield
• C. Equity is already expressed as an after-tax return, while debt is expressed pretax
• D. The formula convention is arbitrary — any consistent approach would give the same WACC

Answer: (B)

Interest expense reduces taxable income: a $100 interest payment at a 25% tax rate saves $25 in taxes, making the net cost to the firm only $75 (= $100 × (1 − 0.25)). Equity payouts (dividends, retained earnings) come from after-tax income — there is no analogous deduction. This asymmetry is real and significant: it gives debt an intrinsic cost advantage, which is why WACC falls as a firm initially levers up. The tax shield is not a convention — it reflects the actual cash cost of each financing source.

Question 3

WACC is the appropriate discount rate to apply to a firm's levered equity cash flows (i.e., cash flows after interest and debt repayment) in a DCF model.

• T. True
• F. False

Answer: False

WACC discounts *unlevered* (enterprise) free cash flows — operating cash flows available to all capital providers before any financing payments. Applying WACC to equity cash flows would double-count the tax shield (once in the rate, once by subtracting interest from cash flows). To value equity directly, you would use the levered cost of equity r_e as the discount rate on cash flows after debt service. WACC is specifically designed for the enterprise value approach, where financing is embedded in the rate rather than the cash flows.

Question 4

As a firm takes on moderate amounts of debt (from an all-equity capital structure), its WACC initially falls because the after-tax cost of debt is lower than the cost of equity.

• T. True
• F. False

Answer: True

This is the interest tax shield effect. Debt is cheaper than equity after tax (no double taxation of interest), so replacing equity with debt at first reduces the blended cost of capital. WACC falls as leverage increases — but only up to a point. At higher leverage, financial distress risk raises both the cost of equity (more volatile equity claims) and the effective cost of debt (higher default spreads), and WACC eventually rises. The optimal capital structure trades off tax benefits against distress costs.

Question 5

Explain why using WACC as the discount rate in an enterprise DCF model correctly captures the value of the interest tax shield, even though the projected cash flows themselves are calculated before any interest payments.

Model answer: WACC uses the after-tax cost of debt r_d(1−T_c), which is lower than the pretax cost. This lower rate increases the present value of the discounted cash flows relative to discounting at the unlevered cost of capital. The difference in present values — the extra value from using the lower WACC — exactly equals (in the Miles-Ezzell and similar frameworks) the present value of the interest tax shield. By embedding the tax benefit in the discount rate, WACC allows the analyst to project simple, unleveraged operating cash flows and still arrive at the correct enterprise value for a leveraged firm.

This is the elegance of the WACC approach: you never explicitly model debt tax shields in the cash flows, yet the valuation implicitly includes them through the lower discount rate. The alternative (APV: Adjusted Present Value) makes this explicit — value the unlevered firm, then add the PV of tax shields separately. Both approaches should give the same answer under consistent assumptions. WACC's convenience is that it collapses two steps into one, but it requires a stable capital structure assumption.