Question

Please show in the graph the WACC formation in the Modigliani Miller's proposition in the case of tax introduction to the model. (Remember as the tax rate increases, it becomes more lucrative to use debt.) (10 pts.)

Answer 1

As the the Modigliani and Miller model, the WACC reduces with the introduction of tax if there is a debt element in the capital structure. This is because interest payments on the debt are tax deductible and hence the overall cost of debt after tax reduces.

For example if the pretax cost of debt is 8% and the tax rate is 30%,

the cost of debt used for WACC calculation will be =pretax cost*(1-tax rate) = 8%*(1-0.3) = 5.6%.

If the tax rate increase, it is even more lucrative to use debt because the overall after tax cost becomes even lower as shown below

Now, in the same example, if the tax rate is 40% instead of 30%, the after tax cost of debt = 8%*(1-0.4) = 4.8%. Hence its better to use debt when taxes are high.

The graphical representation is as shown below: