Question

Which of the following statements is CORRECT? Of the three methods for estimating the cost of equity from retained earnings identified in the textbook, only the DCF method is widely used in practice. The before-tax cost of debt rather than the after-tax cost should be used as the component cost of debt for purposes of developing a company's WACC. The lower the firm's tax rate, the higher will be its after-tax cost of debt and also its WACC, other things held constant. Typically, the average flotation cost of new common stock is much lower than the average flotation cost for new debt.

Answer 1

The lower the firm's tax rate, the higher will be its after-tax cost of debt and its WACC, other things held constant.

After-tax cost of debt is used to compute the WACC of the company. After-tax cost of debt can be computed with following equation:

After tax cost of debt = Pre-tax cost of debt*(1-tax rate)

With above equation we can say that if tax rate reduces then after tax cost of debt increases and company would have less benefit from tax shield thus it will increase the WACC of the company.

Hope this will help, please do comment if you need any further explanation. Your feedback would be highly appreciated.