Question

4 P9-12 The effect The effect of tax rate on WACC K. Bell Jewelers wishes to explore the effect on its cost of capital of the rate at which the company pays taxes. The firm wishes to maintain a capital structure of 40% debt, 10% preferred stock, and 50% common stock. The cost of financing with retained earnings is 10%, the cost of preferred stock financing is 8%, and the before-tax cost of debt financing is 6%. Calculate the weighted average cost of capital (WACC) given the tax rate assumptions in parts a to c. a. Tax rate = 40% b. Tax rate = 35% c. Tax rate = 25% d. Describe the relationship between changes in the rate of taxation and the weighted average cost of capital.

Answer 1

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ke - Microsoft Excel (Product Activation Failed) Add-Ins File Home Insert Page Layout Formulas Data Review View - 2x % Cut 11 A = = = V General A A Wrap Text Merge Merge & Center - Center SF $ 4:0 .00 :.: Insert Delete Format % % , Number Conditional Format Formatting as Table Styles Cell Styles Σ AutoSum : A Fill Sort & 2 Clear Filter Editing Find & Select Alignment Cells Calibri E Copy Paste Format Painter BIU - D Clipboard Font E190 - five 2 EF EG EH 90 91 EI EJ E K EL EM EN EO ED EQ ER ES E EFFECT OF TAX ON WACC 92 TAX RATE = 40% AFTER TAX COST OF DEBT = 6%*(1-0.40) = 3.60% WACC SOURCE WEIGHTS 93 94 95 96 97 98 99 100 101 102 103 DEBT PREFERRED STOCK RETAINED EARNINGS [COMMON STOCK] 40% 10% 50% COC(%) WEIGHTED COST A*B 3.60% 1.44% 8.00% 0.80% 10.00% 5.00% WACC = 7.24% 104 105 106 TAX RATE = 35% AFTER TAX COST OF DEBT = 6%*(1-0.35) = 3.90% 107 108 109 110 KIN Rea WACC SOURCE convexityDGM WEIGHTS COC WEIGHTED COST betaport future INDEX INTL CAP BUD SANDRINE LEASING PV, FV, ANNUITY DIR right clean KE CAPM UTILITY, SHARPE, beta ferences: CF135 YIELD bond portfolio WACCRI™O BO! 120% - -_ + 4 * 10 ENG 25-11-2019 2.ER

ke - Microsoft Excel (Product Activation Failed) Add-Ins File Home Insert Page Layout Formulas Data Review View - 2x % Cut 11 A = = = V General A A Wrap Text Merge Merge & Center - Center SF $ % % , 4:0 .00 :.: Insert Delete Format Conditional Format Formatting as Table Styles Cell Styles Σ AutoSum : A Fill Sort & 2 Clear Filter Editing Find & Select Alignment Number Cells Calibri E Copy Paste Format Painter BIU - D Clipboard Font E1121 - five EF EG EH 104 EL EJ E K EL EM EN EO EP EQ ER ES E 105 нь TAX RATE = 35% AFTER TAX COST OF DEBT = 6%*(1-0.35) = 3.90% 106 107 108 109 110 WACC SOURCE WEIGHTS 111 112 40% COC(%) WEIGHTED COST A*B 3.90% 1.56% 8.00% 0.80% 10.00% 5.00% 113 DEBT PREFERRED STOCK RETAINED EARNINGS [COMMON STOCK] 10% 50% 114 115 116 WACC = 7.36% 117 118 TAX RATE = 25% AFTER TAX COST OF DEBT = 6%*(1-0.25) = 4.50% 119 120 121 122 WACC SOURCE 123 124 KIN Rea WEIGHTS COC(%) WEIGHTED COST A*B betaport future INDEX INTL CAP BUD SANDRINE LEASING PV, FV, ANNUITY convexityDGM DIR right clean KE CAPM UTILITY, SHARPE, beta ferences: CF135 YIELD bond portfolio WACCRI™O BO! 120% - -_ + 9 * 40 ENG 25-11-2019 2. B

ke - Microsoft Excel (Product Activation Failed) Add-Ins File Home Insert Page Layout Formulas Data Review View - 2x % Cut 11 A = = = V General A A Wrap Text Merge Merge & Center - Center SF $ 4:0 .00 :.: Insert Delete Format % % , Number Conditional Format Formatting as Table Styles Cell Styles Σ AutoSum : A Fill Sort & 2 Clear Filter Editing Find & Select C Alignment Cells EL EJ E K EL EM EN EO EP EQ ER ES Calibri E Copy Paste Format Painter BIU - D Clipboard Font EJ137 - fire 2 EF EG EH 118 119 120 121 122 E TAX RATE = 25% AFTER TAX COST OF DEBT = 6%*(1-0.25) = 4.50% WACC SOURCE 123 WEIGHTS COC(%) WEIGHTED COST A*B 124 125 126 127 128 DEBT PREFERRED STOCK RETAINED EARNINGS [COMMON STOCK] 40% 10% 50% 4.50% 8.00% 10.00% 1.80% 0.80% 5.00% 129 WACC = 7.60% 130 131 As tax rate decreases, the advantage of debt financing decreases, so WACC increases so they are negatively correlated here 132 133 134 135 136 137 138 HIM Rea convexity DGM betaport future INDEX INTL CAP BUD SANDRINE LEASING PV, FV, ANNUITY DIR right clean KE CAPM UTILITY, SHARPE, beta ferences: CF670 YIELD bond portfolio WACC RI O 203 120% 1 + 199 * 10 ENG 25-11-2019 ...B