CFA Level ICorporate IssuersMedium
Orion Industrial has a target capital structure of 40% debt and 60% equity. Its before-tax cost of debt is 6%, the marginal tax rate is 25%, and its cost of equity (estimated using CAPM) is 12%. Using the market value weights, what is Orion's weighted average cost of capital (WACC)?
- A9.0%
- B9.6%
- C8.4%
- D10.2%
Show answer & explanationAnswer & explanation
Correct answer: A. 9.0%
After-tax cost of debt = 6% × (1 − 0.25) = 4.5%. WACC = (0.40 × 4.5%) + (0.60 × 12%) = 1.8% + 7.2% = 9.0%.
Why the other options are wrong
- B. Uses the pre-tax cost of debt (6%) instead of the after-tax cost.
- C. Results from an arithmetic error in weighting, not the correct WACC.
- D. Overweights the cost of equity relative to the target weights.
Weighted Average Cost of Capital (WACC)
The blended required return on a firm's capital, weighted by the market value proportions of debt and equity, using after-tax cost of debt.
- WACC = wd×rd×(1−t) + we×re
- Weights should reflect target/market values, not book values
- Used as the discount rate for average-risk projects
Memory trick: Weigh Debt (after tax) and Equity to get the WACC average