Certified Valuation Analyst (CVA) Practice Exam

In the WACC formula, which element is multiplied by (1 - t)?

1. Cost of equity capital

2. Pretax cost of debt

3. Market capitalization

4. Equity contribution

The correct answer is: Pretax cost of debt

The weighted average cost of capital (WACC) formula is used to determine a firm's cost of capital in which each category of capital is proportionately weighted. In this formula, the cost of debt is a crucial component. Specifically, the pretax cost of debt is adjusted by multiplying it by (1 - t), where t represents the corporate tax rate. This adjustment accounts for the tax shield benefit that interest expense provides to a company. Since interest on debt is tax-deductible, using (1 - t) recognizes that the effective cost of this debt is reduced by the amount saved through taxation. By incorporating the tax shield into the calculation, the WACC more accurately reflects the true cost of capital that the firm faces when raising new funds, as it provides a more precise measure by considering the reduction in cash outflow due to the tax deduction. The other elements listed in the options do not receive this tax adjustment in the context of WACC. Therefore, the pretax cost of debt is appropriately multiplied by (1 - t) to yield the after-tax cost of debt, which is an essential input for the WACC calculation.