Describe the impact of corporate taxes on the weighted average cost of capital.

Expert Solution

The WACC is the combined weights of debt , equity and preference capital each multiplied by their respective cost of each capital.

The formula for the WACC is :

weight of debt*cost of debt *(1 - effective marginal corporate tax rate) + weight of equity *cost of equity + weight of preference stock *preference cost of capital.

The impact of corporate taxes on WACC is:

The corporate taxes, only enters the equation in the debt part of the formula. Higher the corporate tax rate, the lower the cost of financing with debt, hence lower is the WACC. When the tax rate falls, the cost of debt rises and the WACC rises.

for example of ABC corp is financing its operations with a capital structure consisting of 30% debt and 70% equity. The cost of equity os 6% and debt is 4% and the corporate tax rate is 15%.

WACC : 0.3*0.04*0.85 + 0.7*0.06

=0.0102 + 0.042

=5.22%

Now, if the corporate taxes rises to 35%, the WACC is :

0.3*0.04*0.65 + 0.7*0.06

=0.0078 + 0.042

=4.98%

So, the WACC falls, with a rise in the corporate taxes.

jeff jeffy answered 2 years ago

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