Chapter 14, Problem 4CRCT

Summary Introduction

To discuss: The reason for using the after-tax amount for the cost of debt but not using it for the cost of equity while calculating the weighted average cost of capital.

Introduction:

The weighted average cost of capital (WACC) refers to the weighted average of the cost of debt after taxes and the cost of equity. The following formula helps to calculate the weighted average cost of capital (WACC):

$WACC=\left(\frac{E}{V}\right)\times R_E+\left[\left(\frac{D}{V}\right)\times R_D\times \left(1-T_C\right)\right]$

Where,

“WACC” refers to the weighted average cost of capital

“R_E” refers to the return on equity

“R_D” refers to the return on debt

“E” refers to the market value of equity capital

“D” refers to the market value of debt

“V” refers to the market value of total capital

“T_C” refers to the corporate tax rate