How is the weighted average cost of capital (WACC) calculated?

The weighted average cost of capital (WACC) is calculated by taking the weighted average of the cost of equity and the after-tax cost of debt. This method reflects the proportional costs of different sources of capital used by a company, which typically includes equity and debt.

To arrive at WACC, you first determine the cost of equity, often estimated using the Capital Asset Pricing Model (CAPM) or other methods, and then assess the cost of debt, which is the effective rate that a company pays on its borrowings, adjusted for the tax benefits of interest expense (since interest is tax-deductible). Each component is then weighted according to its proportion in the overall capital structure of the business. This gives a more accurate reflection of the average rate that a company is expected to pay to finance its assets, making it crucial for decision-making regarding investments and overall financial strategy.

In this context, the other options do not accurately represent the calculation of WACC. Simply averaging the costs without weights does not account for the different contributions of equity and debt. Focusing only on equity market value or averaging total debt and equity fails to capture the nuanced financial impact of each component's cost, as WACC specifically incorporates the costs relative to their share in the total