WACC With and Without the Interest Tax Shield

Cost of Equity and Debt

M-M II: r_E = r_U + (D/E)(r_U − r_D), which increases with leverage. r_D = r_f when the debt is risk-free, then rises once leverage is high enough that debtholders face some default risk.

WACC With and Without the Tax Shield

Pre-tax WACC stays at r_U by M-M I. With taxes, r_wacc = r_U − L·τ_c·r_D, so WACC decreases with leverage.

Cost of equity, r_E

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Cost of debt, r_D

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After-tax cost of debt, r_D(1−τ_c)

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WACC with taxes
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r_U − r_wacc (tax-shield gap)

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