Question

Which of the following statements is true of the impact of tax on the cost of capital of a firm?​

Select one:

a. ​All else being equal, an increase in the corporate tax rate results in a decrease in the weighted average cost of capital.

b. ​The before-tax cost of debt is the cheapest component of the cost of capital since the tax paid is a deductible expense.

c. ​The before-tax cost of debt is always less than the after-tax cost of debt of a firm.

d. ​The tax paid on dividends of preferred stock reduces the amount of funds that the firm can use for financing capital budgeting projects.

e. ​All else being equal, an increase in the equity capital that a firm raises by retaining earnings results in in the increase in the tax rate applicable to the firm.

Answer 1

The answer is a)

All else being equal, an increase in the corporate tax rate results in a decrease in the weighted average cost of capital.

Explanation:

The above statement is true for all companies with debt in their capital structure. Debt requires payment of interest. This interest cost is treated as expense in income statement. Since tax is paid only on revenues less expenses, as expenses increases taxable amount comes down thereby bringing down actual corporate tax payable by the firm.

Thus, inclusion of debt leads to lesser payment of corporate tax. This tax shield advantage increases as corporate tax rate (or interest cost) increases.

This effect of reduced payment of tax and hence increased free cash flows is captured by calcultating weighted average cost of capital using "post-tax interest cost of debt"

Post-tax interest cost of debt = D* interest rate - reduction in tax paid = D* interest rate - D*interest rate * Tax-rate

Where D is debt

Post-tax interest cost of debt = D * Interest-rate * (1-T)

So, the post tax interest cost becomes = Interest * (1-T)

As corporate tax increases, the above post-tax interest cost decreases.

Since after-tax weighted average cost of capital = E/V*Cost of Equity + D/V * Post-tax Cost of Debt

Hence, s tax increases, WACC decreases.

Important Note: When post-tax WACC is used, the calculation of free cash flows in the numerator of DCF formula should not have interest expense deducted. The usage of post-tax WACC takes care of interest tax shield.