Think of WACC as the minimum return your company must earn on its investments just to keep its investors — both lenders and shareholders — happy. If Rajesh & Co. Pvt. Ltd. earns exactly its WACC, the company's value stays flat. Earn more, and value grows. Earn less, and you're destroying wealth. That's why WACC is used as the hurdle rate (minimum acceptable return) in project appraisal and NPV calculations.
WACC is calculated by taking the cost of each source of finance — equity, preference shares, debentures, term loans — and weighting it by that source's proportion in the total capital structure. The formula is:
WACC = Σ (Weight of each source × Cost of that source)
The weights are based on market values ideally (though ICAI problems often give book values — use whatever the question provides). The costs used are post-tax costs. This is the critical part: interest on debt is tax-deductible, so the real cost of debt to the firm is Kd = I(1 − t), where I is the interest rate and t is the tax rate. Dividends on equity and preference are paid from after-tax profits, so no tax adjustment is needed there.
For cost of equity (Ke), the CA Inter syllabus uses three approaches: (1) Dividend Growth Model — Ke = (D₁/P₀) + g; (2) Capital Asset Pricing Model (CAPM) — Ke = Rf + β(Rm − Rf); and (3) Earnings/Price ratio where applicable. CAPM is the most frequently tested approach in recent ICAI papers. For cost of preference shares (Kp), use the IRR-style formula: Kp = [Dividend + (RV − NP)/n] / [(RV + NP)/2], similar to cost of redeemable debentures. Always check whether preference shares are redeemable or irredeemable — the formula changes. This is asked frequently as a 6–8 mark question in Paper 6, often combined with a capital structure or NPV decision.