Certified Valuation Analyst (CVA) Practice Exam

What components contribute to the WACC calculation?

1. A cost of living and inflation rate

2. Cost of equity capital and cost of debt

3. Tax rate and operating profit

4. Market trends and economic forecasts

The correct answer is: Cost of equity capital and cost of debt

The computation of the Weighted Average Cost of Capital (WACC) fundamentally relies on the cost of equity capital and the cost of debt. The rationale behind this is that WACC represents the average rate that a company is expected to pay to finance its assets, reflecting the risk of the investment from both equity and debt holders. The cost of equity represents the return that investors require for their investment in the company's equity, reflecting the risk associated with equity financing. This is often calculated using models such as the Capital Asset Pricing Model (CAPM), which considers the stock's risk relative to the market. On the other hand, the cost of debt is the effective rate that a company pays on its borrowed funds. This cost is generally lower than the cost of equity because debt holders take on less risk than equity investors; they have a higher claim in bankruptcy scenarios and typically receive fixed payments in the form of interest. When calculating WACC, the costs of equity and debt are weighted according to their respective proportions in the firm's capital structure. Additionally, the after-tax cost of debt is used to account for the tax shield afforded by interest expense, thereby ensuring a more accurate reflection of the firm's cost to finance its operations and growth. The other options do not directly contribute to