WACC is calculated using which of the following components?

WACC is calculated using which of the following components?

• A. The cost of equity and the after-tax cost of debt
• B. Total assets and total liabilities
• C. Gross profit and operating income
• D. Dividend payout and retention ratio

Answer: (A)

WACC is the blended cost of all the financing a company uses, reflecting what it costs to attract and retain capital from both equity investors and lenders, weighted by how much of each type of financing the firm uses. The essential components are the cost of equity and the after-tax cost of debt because those are the true returns that investors demand for owning the company’s equity and for lending money. The after-tax aspect comes from the tax deductibility of interest, which lowers the effective cost of debt for the firm. In practice, WACC is calculated by weighting each component by its share of the firm’s total financing and summing them: WACC = (Equity/Total Financing) × Re + (Debt/Total Financing) × Rd × (1 − Tc) [+ any preferred stock term if present]. The other options don’t fit because they describe measures of the firm’s size or profitability (total assets and liabilities; gross profit and operating income) or relate to payout policy rather than the cost of capital (dividend payout and retention ratio).

WACC is the blended cost of all the financing a company uses, reflecting what it costs to attract and retain capital from both equity investors and lenders, weighted by how much of each type of financing the firm uses. The essential components are the cost of equity and the after-tax cost of debt because those are the true returns that investors demand for owning the company’s equity and for lending money. The after-tax aspect comes from the tax deductibility of interest, which lowers the effective cost of debt for the firm. In practice, WACC is calculated by weighting each component by its share of the firm’s total financing and summing them: WACC = (Equity/Total Financing) × Re + (Debt/Total Financing) × Rd × (1 − Tc) [+ any preferred stock term if present].

The other options don’t fit because they describe measures of the firm’s size or profitability (total assets and liabilities; gross profit and operating income) or relate to payout policy rather than the cost of capital (dividend payout and retention ratio).