Question

To understand the advantage of debt capital from a tax perspective in the United States, determine the before-tax and approximated after-tax weighted average costs of capital if a project is funded 60%–40% (D-E mix) with debt capital borrowed at 12% per year. A recent study indicates that corporate equity funds earn 21% per year and that the effective tax rate is 31% for the year.

The tax advantage reduces the WACC from_____ % to_____ % per year.

Answer 1

Before tax wacc = weight of debt × before tax cost of debt + weight of equity × cost of equity

= 0.60 × 12% + 0.40 × 21%

= 7.2% + 8.4%

= 15.6%

After tax cost of debt = before tax cost of debt(1-tax)

= 12% ( 1-0.31)

= 12% (0.69)

= 8.28%

After tax wacc = weight of debt × after tax cost of debt + weight of equity × cost of equity

= 0.60 × 8.28% + 0.40 × 21%

= 4.968% + 8.4%

= 13.368%

The tax advantage reduces the wacc from 15.6% to 13.368% per year.