Question

Why do we use after-tax cost of debt but not after-tax cost of equity when calculating the weighted average cost of capital (WACC)?

Answer 1

The Weighted average cost of capital(WACC) is the cost incurred by the company to raise capital which is a combination of debt and equity.When computing WACC the after tax cost of debt is computed and then factored into WACC calculation.The after tax cost of debt(Cost of debt*(1-tax)) is computed because the interest expense associated with debt is tax deductible.So the after tax cost of debt is computed .But this does not apply to equity as the dividends paid are not tax deductible.As a result there will be no difference between before and after tax cost of equity.So after tax cost of equity is not used when calculating WACC.