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

1.  WACC = 11.26%  (using classical CAPM)

2.  WACC = 11.22% (using tax-adjusted CAPM)

Explanation:

The Weighted Average Cost of Capital (WACC) is the cost of capital of a firm where its equity and debt structure is proportionate.

The CAPM is two types, classic CAPM and tax-adjusted CAPM.

Classic CAPM Formula:

Tax adjusted CAPM Formula:

** same way for , cost of debt

Where

 is the cost of equity

risk free rate

 is the volatility

 is the market return

T is the tax rate

Also, formula for WACC is:

WACC =

Where

E is percentage of equity of the firm

D is the percentage of debt in the firm

 is cost of equity

 is cost of debt

T is tax rate

Now, using classical CAPM Approach:

Cost of Equity:

Cost of Debt:

WACC:

THus,

WACC = 11.26%

Using Tax adjusted CAPM:

Cost of Equity:

Cost of Debt:

Now, WACC:

Thus,

WACC = 11.22%