Question

Summit Builders has a market debt-equity ratio of 1.70, a corporate tax rate of 40 %, and pays 8 % interest on its debt. By what amount does the interest tax shield from its debt lower Summit's WACC?

Answer #1

D/E = 1.70

E = D/1.70

D + E = 1

D + D/1.70 = 1

2.7D = 1.70

D = 1.70/2.70

D = 0.6296296296

Cost of debt component in WACC:

- Without tax shield: Cost of debt * D = 0.08 * 0.6296296296 = 0.05037037037
- With tax shield: Cost of debt * D * (1 - tax rate) = 0.08 * 0.6296296296 * (1 - 0.40) = 0.03022222222

Tax shield lowers the WACC by: 0.05037037037 - 0.03022222222

Tax shield lowers the WACC by 0.02014814815

Tax shield lowers the WACC by 2.014814815%

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