Question

3 (b) Explain briefly how and why the firm’s weighted average cost of capital will be affected in the presence of corporate taxes. How might a firm’s capital investment strategy influence its capital structure choice where corporate taxes exist? (140 words).

Answer 1

Cost of debt is tax deductible while cost of common equity or cost of preferred stock is not.Each source of financing except debt has no impact due to presence of tax.Due to the tax deductible nature of cost of debt,it reduce the overall wieghted average cost of capital(WACC) as it reduces the tax expense.However when there is no corporate tax,then tax deductible nature of debt is not relevant for WACC.That is why presence of tax reduces the overall WACC.

As above said,each source of finace except debt has no impact due to presence of tax.Presence of tax affect the portion of debt in the capital structure.Company will have more debt in its capital structure to save tax expense.Higher the rate of tax,higher will be the portion of debt in the capital structure.Tax expense reduces the earning of the company.If there is no tax,company will be indifferent among each sources of financing.