Question

Explain why the weighted average cost of capital is invariant to the firm’s debt-equity ratio in the absence of corporate taxes.

Answer 1

First of all, I will explain cost of capital. Cost of Capital refers to the cost of raising capital either through debt or equity sources.

Cost of Capital for Equity would mean the cost of dividends that the company has to pay over the period of time, while Cost of Capital for Debt would mean the periodical interest payments that the company has committed while issuing debt.

Now, coming to the taxability of these dividends and Interest Payments, While Interest Payments on Debt are allowed as an expense to the company, Dividend Payments are not. Which means, that the company pays interest first and then pays tax and then the dividends are distributed. So, it leads to a saving of tax on the interest payments for the Company (since the Company is not required to pay tax on that part of the earning)

While calculating Weighted Average Cost of Capital, The Kd i.e. Cost of Debt is taken after tax effect i.e. Rate of Interest (1-Tax Rate) while Ke i.e. Cost of Equity is taken as it is (because of no tax benefit). Now, in the absence of corporate taxes, Interest Rate(1-0) will become Interest Rate only.

Conclusion: WACC is invariant to the firm's debt-equity ratio in the absence of corporate taxes bacause of tax benefit avialbale to the firm on the interest payments made by it.