Corporate finance module 8: Weighted average cost of capital formula

The risk-free rate is 8.97% per annum, the market risk premium is 6.59%, and the tax rate is 27%.

●    A firm’s equity has a CAPM β of 0.99
●    The firm’s debt yields 11.06% per annum.
●    The firm’s debt-to-value ratio is 0.436

A.    What is the firm’s cost of equity capital?
B.    What is the value of the firm’s debt tax shield (as a percent of the firm’s value)?
C.    What is the firm’s after-tax weighted average cost of capital (WACC)?

Part A: The cost of equity capital is the risk-free rate + CAPM β × the market risk premium =

    8.97% per annum + 0.99 × 6.59% per annum = 15.49% per annum

Part B: The value of the firm’s debt tax shield is the market value of the debt × the cost of debt capital × the corporate tax rate.

As a percent of the firm’s value, this is the debt to value ratio × the cost of debt capital × the corporate tax rate

    = 0.436 × 11.06% per annum × 27% = 1.30%

Part C: WACC = rD (1 – Tc) (D/V) + rE (E/V) or

Weighted average cost of capital    = return on debt capital
                                    × (1 – corporate tax rate)
                                    × debt to value ratio
                                    + return on equity capital
                                    × equity to value ratio

= 11.06% × (1 – 27%) × 0.436 + 15.49% × (1 – 0.436) = 12.26%