Question

Summit Builders has a market​ debt-equity ratio of

0.650.65

and a corporate tax rate of

35 %35%​,

and it pays

7 %7%

interest on its debt. The interest tax shield from its debt lowers​ Summit's WACC by what​ amount?

Answer 1

Solution:

As per the information given in the question we have

Debt equity ratio = 0.65

This implies for every Dollar of equity there is $ 0.65 of debt

Thus the percentage of debt in the Weighted average cost of capital is

= debt / ( debt + equity )

= 0.65 / ( 1 + 0.65 )

= 0.65 /1.65 = 0.3939 = 39.39 %

As per the information given in the question we have

Interest Rate on Debt = 7 % ; Corporate Tax rate = 35 % = 0.35   ; Percentage of debt in WACC = 0.3939

Thus the Amount by which the Interest tax shield from debt lowers its WACC is

= Interest Rate on Debt * Corporate Tax rate * Percentage of debt in WACC

= 7 % * 0.35 * 0.3939

= 0.9651 % ( when rounded off to four decimal places )

=0.97 % ( when rounded off to two decimal places )

Thus interest tax shield from its debt lowers​ Summit's WACC by 0.97 %