The Weighted Average Cost of Capital

A company is financed by several kinds of money: shares, bonds, bank loans, preference shares. Each costs a different amount. To judge whether a project is good enough, the company needs a single figure for what its money costs overall, the average return it must earn on everything it has raised so that every provider of finance is paid what they require.

That figure is the weighted average cost of capital, usually called the WACC. It is the most used discount rate in investment appraisal. It is the figure that the directors try to push down, because the lower it is the more valuable the company. But it is a correct discount rate only under conditions that many projects do not satisfy.

This topic explains how to calculate the weighted average cost of capital from market values, how it links to the value of the company, when it may be used to appraise a project, the difference between the average and the marginal cost of capital, and the limits of the figure, with worked examples.

The next topic shows how to find a project-specific rate when the project’s risk is not that of the company.

The weighted average cost of capital was calculated in May Diet, 2026, Question 2(a) (7 marks), using a cost of equity from the dividend growth model and a cost of debt from the internal rate of return of a bond. Read cost of preference shares and convertibles first.

Calculating the WACC

The weighted average cost of capital is the average cost of all the sources of capital a company uses, weighted by their relative amounts.

The costs are the after-tax costs of the previous topics (the cost of equity, the after-tax cost of debt, the cost of preference shares) and the weights are market values, because the market values show what each provider could actually realise and what the company would have to pay for new money.

Book values are not suitable: they record the amounts originally raised, which may be very different from what the capital is worth today.

Method: for each source find its market value and its cost, multiply, add, and divide by the total market value. Example: Delta has 600m ordinary shares priced at ₦5.00; ₦1,000m nominal of 12% redeemable bonds trading at ₦96 per ₦100 nominal, with an after-tax cost of 9.5%; a bank loan of ₦500m at 21% before tax; and 200m 10% preference shares of ₦1, priced at ₦0.85. The cost of equity is 16%. Tax is 30%.

WACC = 664.7 ÷ 4,630 = 14.4%. The weights are 64.8% equity, 20.7% bonds, 10.8% loan and 3.7% preference shares. If the weights had been taken from book values (say equity ₦1,800m, bonds ₦1,000m at 9.5%, loan ₦500m and preference shares ₦200m) the WACC would have been 13.7%, understating the cost because equity, the dearest source, would have been given too small a weight.

The cost of equity in the WACC

The cost of equity may come from the dividend valuation model or from the capital asset pricing model. With a risk-free rate of 8%, a market return of 16% and a beta of 1.2, the capital asset pricing model (CAPM) gives 8 + 1.2 × 8 = 17.6%. Which model is used affects the WACC; the CAPM is generally preferred because it takes explicit account of systematic risk, while the growth model depends on a forecast of growth. In an examination use the model the question names.

WACC and the value of the company

If the company’s annual earnings (profit after tax before interest) are a constant amount for ever, the total value of the company is earnings ÷ WACC.

With earnings of ₦600m:

• at a WACC of 12% the value is ₦5,000m
• at 10% it is ₦6,000m
• at 15% it is ₦4,000m. A lower WACC means a higher value of the company, so the aim of financing policy is to reach the mix of debt and equity that minimises the WACC

Whether such a mix exists is considered in the topics on gearing and capital structure.

When WACC may be used to appraise projects

The WACC is the return that the company’s existing business must earn to satisfy its investors. It is a correct discount rate for a new project only if the project does not change the risk that the investors face. The conditions are:

1. the project is small relative to the company;
2. its business activities and business risk are similar to the company’s;
3. it is financed in a mix similar to the current capital structure (so financial risk is unchanged); and
4. the providers of finance do not change the returns they require because of the project.

If the project is of a different business risk from the company, the WACC is the wrong rate: a risky project discounted at the lower WACC may be accepted when it should not be (its internal rate of return (IRR) is above the WACC but below the return its risk demands), and a safe project may be rejected (its IRR is below the WACC but above what its low risk requires).

In these cases a project-specific rate from the capital asset pricing model is used, as in the next topic.

Average and marginal cost of capital

The WACC is an average of the costs of the capital already in use. The marginal cost of capital is the cost of the next increment of capital raised: new debt may cost more than the average because it is raised in current market conditions, and if a large amount is raised the investors may demand more.

For small projects the average is used; for a project big enough to change the structure or the risk, the marginal cost, or a rate for the project’s own financing and risk, is more appropriate.

The ideas in more depth

Why market values, and which ones

Equity is valued at the number of shares times the price, excluding any dividend about to be paid (ex-dividend). Bonds are valued at the market price, ex-interest; a bank loan, which is not traded, is taken at the amount owed.

If the share price falls the weight of equity falls and the WACC moves towards the cost of debt, which is lower; so the WACC is not a fixed property of the company but depends on market prices.

Why the WACC is not the cost of the cheapest finance

Debt is cheaper than equity, so it is tempting to appraise a project financed by a loan at the cost of the loan. But borrowing more raises the risk of the equity and so its cost (the topic on gearing), and the loan uses up debt capacity that would otherwise be available for other projects. The WACC averages these effects; the cost of the specific finance does not.

Market weights and book weights

The weights in the WACC should be market values, because they show what the capital would cost to raise today. Suppose a company has equity with a market value of \u20a63,000m and a book value of \u20a61,200m, debt of \u20a6900m, a cost of equity of 16% and an after-tax cost of debt of 9%.

On market values the weights are 3,000 \u00f7 3,900 = 76.9% and 900 \u00f7 3,900 = 23.1%, and the WACC is 0.769 \u00d7 16% + 0.231 \u00d7 9% = 14.38%. On book values the weights are 1,200 \u00f7 2,100 = 57.1% and 900 \u00f7 2,100 = 42.9%, and the WACC is 0.571 \u00d7 16% + 0.429 \u00d7 9% = 13.00%. Book weights understate the equity, whose cost is the higher, and so understate the WACC by 1.38 points.

A project accepted at the lower rate may be one that earns less than investors require. Use book weights only when the question gives no market values.

Sources and references

• No accounting standard governs the calculation of the cost of capital. Use the market values given in the question and say which model was used for the cost of equity.

These points are stated as at 5 November 2026.

Worked examples

1. Total.
   3,000 + 960 + 500 + 170 = ₦4,630m.
2. Weight.
   3,000 ÷ 4,630 = 64.8%.

1. WACC.
   664.7 ÷ 4,630 = 14.4%.

1. Value.
   600 ÷ 0.12 = ₦5,000m.

How to answer in the exam

• Set out a table with market value, cost and value × cost for each source.
• Use after-tax costs for debt and market values for the weights, and say so.
• Name the model used for the cost of equity and its inputs.
• State the conditions for using the WACC to appraise a project and whether they hold.

Common mistakes in the exam

• Using book values or nominal values as weights.
• Using the pre-tax cost of debt.
• Using a cum-dividend price for equity or a cum-interest price for debt.
• Leaving out the preference shares or the bank loan.
• Applying the WACC to a project of a different risk without comment.
• Taking the coupon as the cost of the bond.

Quick revision

• WACC = Σ (market value × after-tax cost) ÷ total market value.
• Value of a company with constant earnings = earnings ÷ WACC.
• Use WACC only if business and financial risk are unchanged.
• Marginal cost = cost of the next increment of finance.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

Spotted a mistake? Tell us and we will check it.