Cost of Equity and WACC: A Worked CAPM Example
October 21, 2026
The capital asset pricing model (CAPM) estimates cost of equity as the risk-free rate plus beta times the equity risk premium. With a 4% risk-free rate, a beta of 1.2, and a 5.5% premium, cost of equity is 4% + 1.2 × 5.5% = 10.6%. If the firm is financed 60% by equity and 40% by debt costing 6% pre-tax with a 25% tax rate, WACC is 0.6 × 10.6% + 0.4 × 6% × (1 − 0.25) = 8.16%.
Skip the math and get your answer instantly:
Open the WACC Calculator →Step 1: Cost of Equity
CAPM: Re = Rf + β × (Rm − Rf). The risk-free rate usually comes from long-term government bond yields. Beta measures how much the stock moves relative to the market; a beta of 1.2 means about 20% more volatile than the market. The equity risk premium is the extra return investors demand over risk-free assets, often estimated between 4% and 6%.
Using the example numbers, 4% + 1.2 × 5.5% = 10.6%.
Step 2: After-Tax Cost of Debt
Interest is usually tax deductible, so the effective cost of debt is lower than the stated rate: Rd × (1 − tax rate). With 6% interest and a 25% tax rate, the after-tax cost is 4.5%.
This tax shield is a reason debt is cheaper than equity, although too much debt raises financial risk and increases both costs.
Step 3: Weighting
WACC = E/V × Re + D/V × Rd × (1 − T). With 60% equity and 40% debt, WACC = 0.6 × 10.6% + 0.4 × 4.5% = 6.36% + 1.80% = 8.16%.
Weights should use market values, not book values, because market values reflect what investors would require today.
| Component | Weight | Cost | Contribution |
|---|---|---|---|
| Equity | 60% | 10.6% | 6.36% |
| Debt (after tax) | 40% | 4.5% | 1.80% |
| WACC | 100% | 8.16% |
Using and Misusing WACC
WACC is the usual discount rate for projects with the same risk as the company as a whole. For riskier projects, add a premium, and for safer ones, use a lower rate.
Small input changes can swing the result. A beta of 1.0 instead of 1.2 lowers cost of equity to 9.5% and WACC to 7.5%, so show sensitivity ranges.
Frequently Asked Questions
What does CAPM stand for?
Capital asset pricing model, a formula for expected return based on risk-free rate, beta, and market risk premium.
Why is debt cheaper than equity?
Lenders have priority claims and interest is tax deductible, so the required return and effective cost are lower.
What is a typical equity risk premium?
Estimates generally range between about 4% and 6%, depending on method and period.
Should WACC use book or market weights?
Market values are preferred because they reflect the current cost of raising capital.