Question

4) Describe how the corporate tax rare and flotation costs affect the Weighted Average Cost of Capital (WACC) (15 points)

Answer 1

a). WACC is calculated as sum of weighted costs of capital. Capital is usually comprised of debt and common equity and sometimes, preferred stock.

Cost of debt is calculated as YTM*(1-Tax rate). Since interest payments on debt are tax deductible, they reduce the overall cost of debt, for the company which is why debt has lower cost than equity.

Flotation costs are incurred when a company issues new debt or equity. The effect of flotation cost is to increase the cost of capital. For debt and equity both, flotation costs have the effect of decreasing the price which the company would get for a security. This happens as a certain percentage of the capital raised will be spent as flotation costs. This has the effect of increasing the cost of capital for newly issued security.