Question

Subject : Corporate Finance Theory

Please provide me answers with details that is based on the corporate finance theories

Suppose that the government announced an increase in corporate tax rate from 30% to 35%. The tax rate change was not expected by the market participants including corporate managers, analysts and investors. A CFO says, “We will not change our existing debt amount in response to the tax rate change. The increased tax rate will reduce our firm’s Weighted Average Cost of Capital (WACC). The lower WACC implies that our firm’s free cash flows will be safer under higher tax rate. Further, our firm value estimated by the WACC methods will increase as the discount rate decreases.”

Assess the CFO’s argument by answering the following two questions:

1. How would WACC change after the tax rate increase? If your answer depends on certain conditions, state the conditions clearly in your report.
2. Does firm value increase if WACC indeed decreases after the tax rate increase?

Answer 1

Any changes in tax rate would affect the WACC because component cost of debt is affected by any change in tax rate due to interest paid on debt is allowed as tax deductable expense. Any change in tax rate would directly impact the interest tax shield which would affect the cost of debt and which in turn afects the WACC. A increase in tax rate means more interest tax shield and which results in lower after tax cost of debt and this results in reduction in WACC and vice versa.

Yes value of the firm increases with any decrease in WACC because value of firm is calculated by dividing the operating income by WACC and any change in WACC would results in change in value of firm. if WACC will increase value of firm will decrease and any decrease in WACC will increase the value of firm.

value of firm = operating profit/WACC