WACC, derived

A firm funded by both debt and equity has a blended cost of capital — each supplier's required return, weighted by how much of the money they provide.

$WACC = \frac{E}{D+E} \times k_e + \frac{D}{D+E} \times k_d \times (1-t)$

Work the problem:

$WACC = 0.70 \times 14\% + 0.30 \times 7\% = 9.8\% + 2.1\% = \textbf{11.9\%}$

Why market values, not book values

The weights must be market values of equity and debt, not balance sheet figures.

The reason is what the rate represents: the return currently required by suppliers of capital. A company whose equity has a book value of ₹500 crore and a market value of ₹5,000 crore is one whose shareholders have ₹5,000 crore at stake — that is the amount demanding a return.

Using book equity is the single most common WACC error, and it is one-directional: for a company trading above book, it overweights debt, understates WACC, and makes every project look better than it is.

Debt is usually closer to book value, so the error concentrates in the equity weight.

Why the tax adjustment sits only on debt

Interest is deductible; dividends are not. The after-tax cost of debt is the real cost to the firm, and it is why debt looks cheap.

This is also the entire source of the capital structure argument in chapter 10. If debt is cheaper after tax, why not use more of it? That question has a precise answer and it is not "no limit".

What WACC assumes

Four assumptions, and each one is a condition on when the rate may be used:

1. The project has the same business risk as the firm's existing operations.
2. The project will be financed in the firm's existing proportions.
3. Those proportions are stable over the project's life.
4. The firm can access capital at those costs.

When WACC is the wrong rate

The second half of the problem. A company 30% debt and 70% equity in its established business, appraising a new venture in an unrelated industry, should not use 11.9%.

The discount rate represents the risk of the cash flows being discounted, not the average risk of the company doing the discounting. A stable utility entering a volatile new sector would be discounting risky cash flows at a safe company's rate, and the result is systematic: risky projects look better than they are and safe ones look worse.

Over time that destroys value quietly, because a company applying one hurdle rate across divisions of different risk accepts the wrong projects in both.

The fix is a divisional or project-specific rate: take betas of listed companies in the target industry, un-lever them, re-lever at the financing the project will actually carry, and build a cost of equity from that.

Three other situations where firm-wide WACC misleads:

A project financed differently from the firm. Project finance and infrastructure often carry far more debt than the sponsor does.

Capital structure that changes materially over the life. A rate computed at today's mix is wrong for a project that deleverages.

A firm in distress. Both costs of capital are moving, and the weights are unstable.

Where the regulatory limits bite

A firm cannot choose any capital structure it likes. SEBI's buyback regulations require that after a buyback, debt shall not be more than twice paid-up capital and free reserves — a direct constraint on returning capital in a way that leverages the balance sheet. Chapter 13 works through that decision; here it is enough to note that the weights in WACC are partly a regulatory variable, not purely a management choice.

The honest status of the number

Chapter 8 showed the cost of equity is a range of several percentage points. WACC inherits that, narrowed slightly by the debt component.

So a WACC of "11.9%" is better read as "roughly 11 to 14%", and the right way to use it is to test whether the decision survives across the range. A project that is positive at 11% and negative at 13% has not been appraised; it has been assumed.

The point

WACC weights the cost of equity and the after-tax cost of debt by their market-value shares. Book weights understate it for any company trading above book, and the tax adjustment belongs only on debt — which is what makes capital structure a question at all. It is the right rate only for projects with the firm's own business risk and financing mix, so applying one firm-wide hurdle rate across divisions of different risk systematically accepts the wrong ones.