Question

Describe the impact of i) gearing (i.e. financial leverage); and ii) tax on the cost of capital.

Answer 1

The impact of gearing on the cost of capital:

first let us know the formula for calculating the cost of capital:

Re = WEIGHT OF DEBT*COST OF DEBT * (1- TAX RATE ) + WEIGHT OF EQUITY*COST OF EQUITY

Taking on leverage, reduces the cost of capital for a firm. Obtaining debt as a source of finance is cheap and it leads to reduction of  the cost of capital. Debt creates a tax shield.

Tax on cost of capital: The tax reduces the cost of capital,as the interest payments on debt are tax deductible. The taxes do not affect the cost of equity or cost of preference stock because payments made on equity or preference is not tax deductible.

So, if the cost of debt is 8% and the tax rate is 35%,so the net cost of debt is = 8*0.65

=5.2%.