Question

Consider a company that has β equity = 1.5 and β debt = 0.4. Suppose that the risk-free rate of interest is 6 percent, the expected return on the market E(rM) = 15 percent, and the corporate tax rate is 40 percent. If the company has 40 percent equity and 60 percent debt in its capital structure, calculate its weighted average cost of capital using both the classic CAPM and the tax-adjusted CAPM.

Answer 1

β_Equity = 1.5

β_Debt = 0.4

Cost of equity = Risk-free rate + [β_Equity x (Expected return on the market - Risk-free rate)]

Cost of equity = 6% + [1.5 x (15% - 6%)]

Cost of equity = 19.5%

Cost of debt = Risk-free rate + [β_Debt x (Expected return on the market - Risk-free rate)]

Cost of debt = 6% + [0.4 x (15% - 6%)]

Cost of debt = 9.6%

After-tax cost of debt = Cost of debt x (1 - Tax) = 9.6% x (1 - 0.40) = 5.76%

WACC using classic CAPM

WACC = (Weight of equity x Cost of equity) + (Weight of debt x Cost of debt)

WACC = (0.40 x 19.5%) + (0.60 x 9.6%) = 7.8% + 5.76%

WACC = 13.56%

WACC using tax-adjusted CAPM

WACC = (Weight of equity x Cost of equity) + (Weight of debt x After-tax cost of debt)

WACC = (0.40 x 19.5%) + (0.60 x 5.76%) = 7.8% + 3.456%

WACC = 11.256%