The effect of tax rate on wacc: k. bell jewelers wishes to exlore the effect on its cost of capital of the rate at which the company pays taxes. the firm wishes to maintain a capital structure of 40% debt, 10% preferred stock, and 50% common stock. the cost of financing with retained earnings is 10%, the cost of preffered stock financing is 8%, and the before-tax cost of debt financing is 6%. calculate the weighted average cost of capital (wacc) given the tax rate assumptions in parts a to c.

a. tax rate= 40%

b. tax rate= 35%

c. tax rate= 25%

d. describe the relationship between changes in the rate of taxation and the weighted average cost of capital.

a. 7.24

b. 7.36 %

c. 4.50%

d. Please check the explanation listed below.

Explanation:

Cost of Financing with :

Retained Earnings or Equity or Common Stock (Ke) = 10%

Preferred Stock (Kp) = 8%

Debt (Kd) = 6% (1- Tax Rate)

Capital structure

Debt:Preferred Stock:Common Stock

40:10:50

Weight of Debt (Wd) = 40%

Weight of Preferred Stock (Wp) = 10%

Weight of Common Stock (We) = 50%

Weighted Average Cost of Capital (WACC) = (Kd x Wd) + (Kp x Wp) +(Ke x We)

(A). Tax Rate = 40% or 0.40

      Kd = 6% (1-0.40) = 3.60%

WACC = (Kd x Wd) + (Kp x Wp) +(Ke x We)

          = (0.036 x 0.40) + (0.08 x 0.10) + (0.10 x 0.50)

          = 7.24 % or 0.0724

(B). Tax Rate = 35% or 0.35

      Kd = 6% (1-0.35) = 3.90%

WACC = (Kd x Wd) + (Kp x Wp) +(Ke x We)

          = (0.039 x 0.40) + (0.08 x 0.10) + (0.10 x 0.50)

          = 7.36 % or 0.0736

(C). Tax Rate = 25% or 0.25

      Kd = 6% (1-0.25) = 4.50%

WACC = (Kd x Wd) + (Kp x Wp) +(Ke x We)

          = (0.045 x 0.40) + (0.08 x 0.10) + (0.10 x 0.50)

          = 7.60% or 0.0760

(D). Interest on debt is a tax deductible expense and if debt is a part of capital structure of a company, it helps in maximisation of wealth of shareholders' of that company as it reduces effective cost of capital by deducting tax component from the overall cost of capital.

In the question, Weight of Debt in Capital remains same, so with decrease in tax rate from part (A) to (C), cost of capital increases due to increase in after tax cost of debt. Or in other words we can say that increase in tax rate reduces cost of cost other things remaining constant.