FNCE20005 · Corporate Financial Decision Making
Cost of Capital and WACC
A firm is financed by a blend of debt and equity, each demanding its own return, and the weighted average cost of capital (WACC) blends them into the single hurdle rate the firm must clear on same-risk projects: WACC = kd(1 − te)(D/V) + ke(E/V), using market-value weights and the after-tax cost of debt (interest is deductible; dividends are not). The cost of debt kd is the market rate today for the firm's credit risk — not the historical coupon, and not mechanically the YTM. The distinctive Australian content — and the part the exam loves — is dividend imputation: franking credits hand company tax back to resident shareholders, so the tax that truly burdens the firm is an effective rate te = tc(1 − λ), where λ is the fraction of company tax shareholders reclaim. A smaller te shrinks the debt tax shield, raising WACC above the classical figure and quietly undercutting the usual case for debt — the link straight into capital structure. Two killers recur: book instead of market weights, and forgetting te ≠ tc under imputation.
What this chapter covers
- 011 The cost of debt kd — risk-free rate plus a default spread, after tax
- 022 The WACC — market-value weights, target structure, same-risk rule
- 033 Dividend imputation and franking — grossing up a dividend, the franking credit
- 044 The effective tax rate te = tc(1 − λ) under imputation
- 055 Worked example — WACC under imputation
Worked example: WACC under dividend imputation
- +1Effective tax rate: te = tc(1 − λ) = 0.30 × (1 − 0.60) = 0.30 × 0.40 = 0.12 — far below the 0.30 statutory rate, because franking has done most of the work.
- +1After-tax cost of debt: kd(1 − te) = 6% × (1 − 0.12) = 6% × 0.88 = 5.28%.
- +1Weight the debt term: 5.28% × 0.40 = 2.112%.
- +1Weight the equity term: 18% × 0.60 = 10.80% (no tax factor on equity — dividends are not deductible).
- +1Add the two: WACC = 2.112% + 10.80% = 12.91%.
Key terms
- Weighted average cost of capital (WACC)
- WACC = kd(1 − te)(D/V) + ke(E/V), the blended hurdle rate for a project of the firm's own risk and gearing. It uses market-value weights and the after-tax cost of debt.
- Cost of debt (kd)
- The return debt-holders require today — the risk-free rate plus a default spread set by the firm's credit rating. It is the current market rate, not the historical coupon, and is taken after tax in WACC because interest is deductible.
- Dividend imputation
- The Australian system (since July 1987) under which company tax already paid is credited to resident shareholders via franking credits, removing the double taxation of the classical system. A cash dividend is grossed up by dividing by (1 − tc) to recover the pre-tax profit; the franking credit is tc times that grossed-up figure.
- Effective tax rate (te)
- The tax that truly burdens the firm's after-tax cash flows under imputation: te = tc(1 − λ), where λ is the fraction of company tax shareholders reclaim. λ = 0 gives the classical case (te = tc); λ = 1 gives pure imputation (te = 0).
- Market-value weights
- The shares D/V and E/V in WACC must use the market value of debt and equity (price × shares), ideally the target capital structure, not stale book values that understate equity.
Cost of Capital and WACC FAQ
Why use market-value weights, not book values, in WACC?
Book values are stale accounting figures that understate the market value of equity, so book weights give the wrong blend. WACC should weight each source by its market-value share of total capital V = D + E, ideally the gearing the firm is moving toward (its target structure), not a one-off snapshot. Using book weights is one of the two killers the exam plants.
How does dividend imputation change WACC?
Under imputation, franking credits refund company tax to resident shareholders, so the tax that truly burdens the firm is the effective rate te = tc(1 − λ), which is below the statutory rate. You must use te, not tc, in the after-tax debt term. Because te is smaller, the debt tax shield is smaller, after-tax debt is dearer, and WACC comes out higher than the classical figure. This is the AU twist the exam tests.
How do I gross up a franked dividend?
Divide the cash dividend by (1 − tc) to recover the pre-tax profit it came from: for example 70/(1 − 0.30) = 100. The franking credit is the difference, tc times the grossed-up figure: 0.30 × 100 = 30, exactly the company tax already paid. The most common error is multiplying by (1 − tc) instead of dividing. Franking benefits flow only to resident shareholders — do not apply the credit to a foreign holder.
Can I use one firm-wide WACC for every project?
No. WACC is the hurdle only for projects matching the firm's own risk. Using one company WACC over-rewards high-risk divisions (their true hurdle is higher) and starves low-risk ones. The fix is to use the WACC of comparable pure-play firms whose risk matches the project — a conglomerate's mining arm should not be judged at the same rate as its retail arm.
Exam move
Master the imputation-WACC recipe as a fixed chain: compute te = tc(1 − λ), take the after-tax cost of debt kd(1 − te), weight each cost by its market-value share, then add. Always check the equity term carries no tax factor and that you used te, not the statutory rate. Practise the franking sub-questions separately — gross up by dividing by (1 − tc), find the franking credit as tc times the grossed-up dividend, and trace who actually wins (a 0% fund gets a cash refund; a top-rate holder still owes a little). Keep the two killers front of mind: market not book weights, and te ≠ tc under imputation. Be ready to contrast imputation with classical tax — the direction (imputation raises WACC, weakens the case for debt) matters more than the decimals.
