CTA Level Weighted Average Cost of Capital (WACC)
Complete Notes + Worked Examples
1. Definition and Purpose
WACC is the average required return demanded by all providers of finance, weighted by market
values. It is used as a hurdle rate in NPV, DCF valuation, investment appraisal, and financing
decisions.
2. Core Formula
WACC = (E/V)Ke + (D/V)Kd(1-T) + (P/V)Kp, where market values must be used.
3. Cost of Equity
CAPM: Ke = Rf + beta(Rm-Rf). Dividend Growth Model: Ke = D1/P0 + g.
4. Cost of Debt
Use redemption yield/YTM where possible. After-tax cost = Kd(1-T) because interest is tax
deductible.
5. Preference Shares
Kp = Dp/P0 for irredeemable preference shares.
6. Market Value Weights
CTA exams heavily test the difference between book and market values. Always prefer market
values.
7. Geared and ungeared beta
Beta adjustments are examinable in project-specific WACC and divisional valuations.
8. Flotation Costs
Adjust the issue price downward: Ke = D1/[P0(1-F)] + g.
9. Project-specific WACC
Adjust discount rate for project risk, foreign risk, divisional risk, and capital structure differences.
10. Limitations
Constant gearing assumption, estimation errors, changing tax rates, and project risk mismatch.
Worked Example 1
Equity = 60% at 14%; Debt = 40% at 10%; Tax = 30%. WACC = 0.6(14%) + 0.4(10%)(1-0.3) =
8.4% + 2.8% = 11.2%
Worked Example 2: CAPM
Rf = 8%, beta = 1.2, market premium = 6%. Ke = 8% + 1.2(6%) = 15.2%
Exam Traps
• Using book values instead of market values
• Forgetting debt tax shield
• Using historical coupon instead of YTM
• Applying company WACC to higher-risk projects
• Ignoring flotation costs in rights issues