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If the federal government eliminated corporate taxes, what would happen to the WACC?

If the federal government eliminated corporate taxes, what would happen to the WACC?

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Expert Solution

If the taxes are eliminated, the cost of capital (WACC) will increase because Corporate taxes provides with tax deduction on the Interest rate paid on debt. In other words , There is a Interest rate shield provided to the company who obtain their capital through debt.

If a company obtain 100 millions through debt and Cost of debt is 10 percent, if it is to be followed with a corporate rate of 40%, the cost of debt falls to 10( 1-.4) =6% . This is just because of tax deduction offered by corporate taxes on interest rates .

In the same scenario, if the corporate taxes are abolished, the cost of debt will remain same as there is no tax to provide any interest rate shield.

Taxes doesn't affect cost of common equity or cost of preferred equity. It only lowers cost of debt resulting into overall lower rate of WACC.

So Elimination of corporate taxes will increase WACC because Cost of debt will increase.

jeff jeffy answered 2 years ago
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