Question

Why is it important to consider corporate tax rates and financial structure to derive the weighted average cost of capital (WACC) of a company? Explain.

Answer 1

It is important to calculate WACC to calculate the required cost of capital. But to calculate WACC we need to consider Corporate Tax Rates and Financial Structure due to following reasons:

1. Financial Structure: Financial Structure consists of various sources of finances, like Equity, Preference Share, Debt etc. These sources have different cost of the Source. For example: Debt is cheaper than Equity and Preference. Similarly, Preference Share Capital is cheaper than Equity. The reason behind the difference in their cost due to risk. Debt have least risk because they will have priority of repayment during the liquidation of the company. On the other hand Equity has the highest risk because it gets its payment at last during the liquidation. Hence Financial Structure has a impact on WACC.

Furtehr, Debt is cheaper due to the Tax Deduction which we get on the interest paid on Debt.

2. Corporate Tax Rate: It is the tax rate which is paid on corporate profits. It is important to consider corporate Tax Rate while calculating WACC because corporate Tax Rate make Debt cheaper source because interest on Debt is Tax Deductible.

Example:

	Company A	Company B
Capital Structure:
Equity	600000	1000000
10% Debt	400000	0
Total Capital	1000000	1000000
EBIT (Earning before Interest and Tax)	100000	100000
Less: Interest on Debt	40000	0
Profit after Tax	60000	100000
Less: Corporate Tax @ 30%	18000	30000
Profit after Tax	42000	70000

In the above example company A has paid less tax i.e. (30000-18000) of $12000 due to the Tax deductible interest of $40000.

Hence the real cost of debt = Interest Rate (1- Tax Rate)

For the above example, the Cost of Debt = 10% (1 - 0.30) =

Cost of Debt = 10% x 0.70

Cost of Debt = 7%