Question

Effective January 1, 2018, U.S. corporate tax rates were reduced from a maximum 35% to 21%. What impact does this have on a company’s WACC? Does it have a greater impact on companies that use a high level of debt than on companies that use a lower level of debt? Explain. Is it likely to have an impact on a company’s capital structure, i.e., might a company change its weighting of debt vs equity?

Answer 1

The WACC increases slightly. It has a greater impact on companies that use high level of debt. WACC uses after-tax cost of debt and as interest payments are tax deductible, after-tax cost of debt is equal to pre-tax cost of debt multiplied by 1-tax rate. Hence, higher the tax rate more is the benefits and thus lesser is the after-tax cost. Therefore, decrease in tax rate means lesser benefits and hence WACC increases. In case of high debt companies, WACC is majorly coming from cost of debt and as cost of debt is affected by tax rate, the impact is felt the most for high debt firms.

Yes, it is likely to change the capital structure and a company might increase the weighting of equity. Obviously the optimum capital structure has to be found first which captures the tradeoff between bankruptcy costs and tax benefits of debt.