Question

To understand the advantage of debt capital from a tax perspective in the United States, determine the before-tax and approximated after-tax weighted average costs of capital if a project is funded 40%–60% (D-E mix) with debt capital borrowed at 9% per year. A recent study indicates that corporate equity funds earn 14% per year and that the effective tax rate is 30% for the year. The tax advantage reduces the WACC from________ % to __________% per year.

Answer 1

Given, D-E (Debt-Equity) mix = 40%-60%, it means there is 40% debt and 60% equity.

Before-tax WACC = (% of Debt capital x Rate of Debt capital) + (% of Equity capital x Rate of Equity capital)

= 0.4 x 9% + 0.6 x 14%

= 3.6% + 8.4%

= 12%

After-tax WACC = [% of Debt capital x Rate of Debt capital x (1 - Tax rate)]) + (% of Equity capital x Rate of Equity capital)

= [0.4 x 9% x (1 - 0.30)] + (0.6 x 14%)

= (3.6% x 0.7) + 7.2%

= 2.52% + 8.4%

= 10.92%

So, tax advantage reduces the WACC from 12% to 10.92% per year.