Question

The management at ABC Co will consider the tax effect on the cost of capital for new capital projects, the current policy of capital structure is 40% debt, 60% common shares (no preferred stock), cost of financing 7%, retained earnings financing cost is 14%, compute the WACC for the following tax assumptions 39%, 36%, 25%, all else being equal if the tax rate goes up, what is the effect on WACC?

Answer 1

WACC=(weight of debt*after tax cost of debt)+(weight of equity*cost of equity)

a. If tax=39%

after tax cost of debt=cost of financing*(1-tax rate)=7%*(1-39%)=4.27%

WACC=(40%*4.27%)+(60%*14%)=10.11%

b. If tax=36%

after tax cost of debt=cost of financing*(1-tax rate)=7%*(1-36%)=4.48%

WACC=(40%*4.48%)+(60%*14%)=10.19%

c. If tax=25%

after tax cost of debt=cost of financing*(1-tax rate)=7%*(1-25%)=5.25%

WACC=(40%*4.48%)+(60%*14%)=10.50%

2. If tax rate goes up, the WACC decreases which is a good thing.

Becasue of the tax advantage on the debt, higher tax results in decrease in the WACC.