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In WACC calculations, what's the tax shield advantage debt capital provides??

In WACC calculations, what's the tax shield advantage debt capital provides??

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Answer #1

In WACC calculation, the equation used is as given below:

WACC = Cost of Debt x (1-Tax Rate) x Debt Ratio + Cost of Equity x Equity Ratio

The expression "Cost of Debt x (1-Tax Rate)" reduces the cost of debt by an amount equivalent to the firm's tax shield advantage which is given as Tax Shield Advantage = (tax rate x perpetual debt capital x interest rate) / cost of debt. The expression is also known as the after-tax cost of debt and it reduces the cost of using debt capital, thereby enhancing firm value which is the same impact that the interest tax shield has on the firm's value.

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