Question

The firm is considering using debt in its capital structure. If the market rate of 5% is appropriate for debt of this kind, what is the after tax cost of debt for the company? What are the advantages and disadvantages of using this type of financing for the firm?

Answer 1

Firms capital structure is composition of debt and equity. The WACC helps to understand the weighted cost of capital for the firm.

Cost of common stock (r_s): r_s represents cost of common stock. This represents the rate of return which is expected by shareholders.

Cost of debt (r_d): r_d represents cost of debt. Cost of debt is straight forward understanding about borrowing cost a firm bear. Equation: r_d = Outstanding loan x Rate of interest. Cost of debt is given tax impact.

Weight Average Cost of Capital (WACC): WACC represents Weighted Average Cost of Capital. In nutshell WACC helps us to reach to the composite cost of capital of the firm.

Equation: WACC = w_dr_d (1 – T) + w_psr_ps + w_s r_s (New notation; T = Tax rate, w_{d =} Size of debt or weight of debt, w_ps = Weight of preference share, r_ps = Cost of preference share, w_s = Weight of common equity. Debt is given tax impact because tax benefits are availed by firms by charging debt to profit and loss. Hence that impact is negated here.

Basically, above equation give the effect of cost of each capital component. Right from common equity or equity, preference share and debt.

WACC represents Weighted Average Cost of Capital.

Equation:

WACC = w_dr_d (1 – T) + w_psr_ps + w_s r_s

Notations:

w_s= Weight of equity,

r_s= Cost of equity share,

T = Tax rate,

w_{d =} Weight of debt,

r_d = Cost of debt

w_ps = Weight of preference share,

r_ps = Cost of preference share,

Debt in above formula is given tax impact because tax benefits are availed by firms by charging debt to profit and loss. Hence that impact is negated here.

Let’s demonstrate this,

1)      Profit Loss account of a firm with debt of 10 million @5% p.a and equity be 10 million @ 7%:

Gross profit = 1 million
Interest cost = 0.5 million
Profit before tax = 0.5 million
Tax @ 50% = 0.25 million

Therefore, PAT = 0.25 million (0.5*50% tax)

We can make observation here that tax portion is getting reduced only due to impact of interest cost. If there were no debt then tax would have been 0.5 million instead of 0.25 million.

This means bringing a debt in firm reduced the taxability and enhanced returns to equity. Higher debt doesn’t increase in the PAT numbers but it gives capacity to take more projects at lower cost. Lower cost is achieved due to bringing more debt in to a capital structure. Debt has two impacts 1) It can be charged in P&L where as equity cost is not charged before tax 2) Debt costing gives one more impact on P&L that it is a cost and tax in not charged on debt cost.

That is why WACC = w_dr_d (1 – T) + w_psr_ps + w_s r_s , equation takes leverage of lowering debt cost tune to tax impact. If debt cost is 5% and tax is 50% then debt attributes only 2.5% (5% x 50%) of the cost to WACC formula.

Advantages and disadvantages:

We can conclude the advantages for including debt financing is that firm can reduce the cost of capital, firm can do expansion by borrowing easily and same time that increases return to equity, firm can easily raise capital from the debt.

On other hand we can conclude the disadvantages for debt financing as; firm will be exposed to interest rate risk which means if the debt financing cost increases at time of refinancing debt then firm will face difficulties, excess leverage attracts lower rating for the firm which increases the debt cost, in times of low liquidity firm can face huge stress in raising debt from market.