Question

P9-12 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 6º. 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% Ad. Describe the relationship between changes in the rate of taxation and the weighted average cost of capital.

Answer 1

Weighted average cost of capital= the weight of debt* after-tax cost of debt+ weight of common equity* the cost of common equity+ weight of preferred equity* cost of preferred equity

A: WACC = 40%*6%*(1-40%)+50%*10%+ 10%*8%

=7.24%

B: WACC =40%*6%*(1-35%)+50%*10%+ 10%*8%

=7.36%

C: WACC = 40%*6%*(1-25%)+50%*10%+ 10%*8%

=7.6%

D: we observe that as the tax rate increases, the cost of debt decreases due to greater tax advantage. In contrast, the cost of debt increases as the tax rate decreases due to lesser tax advantage. Hence we can conclude that if the pretax cost remains constant, the weighted average cost of capital is inversely related to the tax rates.