What is WACC and which inputs determine its value?

• A. WACC is fixed at 0% for cash-heavy firms
• B. WACC is the weighted average cost of capital; determined by the cost of debt (after tax), cost of equity, and the relative weights of debt and equity.
• C. WACC is only cost of equity
• D. WACC is calculated as net income divided by enterprise value

Answer: (B)

WACC is the blended required return on a company’s overall financing, coming from both debt and equity. It’s the rate that reflects the mix of funding the firm uses and serves as the discount rate for evaluating projects and valuing the business.

The inputs are threefold: the cost of each financing source and the relative weights of those sources in the capital structure. The cost of debt is the rate lenders require on the company’s borrowings, but it’s after-tax because interest is tax-deductible, so you use Rd × (1 − Tc). The cost of equity is the return shareholders expect for owning the stock, typically estimated with methods like CAPM. The weights are the shares of debt and equity in the total financing, usually based on market values (D/V and E/V) to reflect how the firm is actually financed.

Putting it together, WACC = (E/V) × Re + (D/V) × Rd × (1 − Tc). This formula shows why all three inputs matter: how costly each funding source is and how much of the total funding each source represents.

WACC isn’t 0% just because a firm holds a lot of cash, isn’t solely the cost of equity, and isn’t computed as net income divided by enterprise value.