Explain why the cost of debt is tax-affected but the cost of equity is not.

What the interviewer is actually testing

This lesson is a favorite because it has multiple small, precise sub-questions that separate candidates who memorized the WACC formula from those who understand where every input actually comes from.

The core signals of mastery:

1. You use YTM, not the coupon, for cost of debt, and can explain why in one sentence: the coupon is historical, YTM is the market's live estimate of what the company would pay to borrow today.

2. You know the synthetic rating fallback for private companies or thinly-traded debt: interest coverage ratio mapped to a rating, then risk-free plus spread. Even naming Damodaran's table signals real preparation.

3. You apply the tax shield correctly and can explain why interest gets a tax benefit and dividends don't (deductibility), and you default to the marginal tax rate, flagging that NOLs can push the effective near-term cash tax rate toward zero.

4. You use target, not current, capital structure weights, and can explain why: a company's current leverage may be transient (post-LBO delevering, a one-off acquisition-driven debt raise) and doesn't represent its steady-state financing mix.

5. You never use book value of equity. This is a fast, binary tell: book equity is an accounting number, sometimes negative, and irrelevant to what the market thinks the company is worth. A candidate who reaches for book equity under any pressure has a gap.

Weak candidates recite the WACC formula correctly but can't explain where Rd, t, or the weights actually come from when pushed, which is exactly where this lesson's follow-ups live.

Common traps

Trap 1: Using the coupon rate as the cost of debt. The coupon reflects credit conditions at issuance, which can be stale by years.

Say it out loud: "I'd use the yield to maturity on the company's traded debt today, not the coupon: the coupon is a historical contractual rate, and YTM is the market's current estimate of what the company would actually pay to borrow right now."

Trap 2: Forgetting the tax shield, or applying it to the wrong side. Some candidates tax-affect the cost of equity, or forget to tax-affect debt at all.

Say it out loud: "Only the cost of debt gets tax-affected, because interest is tax-deductible and the equity cost isn't: the after-tax cost of debt is Rd times one minus the tax rate."

Trap 3: Using the effective tax rate off the income statement. The historical effective rate is distorted by one-time items and doesn't represent the marginal rate the company will actually pay on the next dollar of pre-tax income.

Say it out loud: "I'd use the marginal statutory rate the company actually faces going forward, not the trailing effective rate, which can be skewed by one-time items or NOLs."

Trap 4: Using current instead of target capital structure weights. A company recently loaded up with acquisition debt, or one still delevering post-LBO, doesn't intend to stay at that leverage forever.

Say it out loud: "I'd weight by the company's target, sustainable capital structure, not whatever its balance sheet happens to show today, which may be transient."

Trap 5: Using book value of equity anywhere in the calculation. This is the single fastest way to signal you don't understand what WACC is measuring.

Say it out loud: "Equity weight always uses market capitalization: book equity is an accounting figure that can even go negative and has no bearing on what the market believes the company is worth."

Trap 6: Assuming WACC always falls as leverage rises. True only up to a point; beyond that, rising distress risk pushes both Re and Rd up faster than the tax shield saves.

Say it out loud: "WACC doesn't fall indefinitely with leverage: added debt is cheap and tax-advantaged at first, but as leverage rises, both the cost of equity and eventually the cost of debt rise with distress risk, so WACC traces something closer to a shallow U."