Question

What are the three elements of the Weighted Average Cost of Capital formula? Which of the elements are impacted by taxes?

Answer 1

Weighted average cost of capital is the rate a company will pay on average of all the securities of the company. The three securities are

• Equity
• Preference
• Debt

WACC is the minimum return a company needs to earn on the existing asset base. This is dependent on the capital structure of the company.

The cost of debt, cost of equity and cost of preference shares are the three elements.

• Cost of debt is impacted by taxes. this is because interest paid on debt is tax deductible and henceforth we take the after tax cost of debt.
• When we talk about equity and preference, there is no tax benefit. However, Dividend distribution tax is a part of cost of equity and cost of preference.