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What the interviewer is testing
Whether you know the formula, can explain each input (weights, cost of equity, after-tax cost of debt), and can handle the private-company beta follow-up.
Answer framework
- Define it: the blended required return of all capital providers.
- Formula: WACC = E/(D+E) x cost of equity + D/(D+E) x cost of debt x (1 - tax rate), plus a preferred term if relevant.
- Weights: market values or a target capital structure.
- Cost of equity: CAPM, risk-free rate + levered beta x equity risk premium.
- Cost of debt: current yield or borrowing rate, after tax because interest is deductible.
Sample answer
WACC is the blended required return of all capital providers. WACC = E/(D+E) x cost of equity + D/(D+E) x cost of debt x (1 - tax rate), plus a preferred-stock term if relevant. I use market values or a target capital structure for the weights.
Cost of equity comes from CAPM: risk-free rate + levered beta x equity risk premium. Some practitioners add a size or company-specific premium. The risk-free rate is usually a long-term government bond yield in the currency of the cash flows.
Cost of debt is the current yield or borrowing rate, taken after tax because interest is tax-deductible.
Likely follow-ups
Common mistakes
- Using book values for the weights without saying why.
- Forgetting to tax-effect the cost of debt.
- Using an unlevered beta in CAPM for the cost of equity.
- Using the private company's own (non-existent) beta instead of comparables.
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Related questions
Based on questions #27, #28, #29 in the full question bank.