P912 The effect of tax rate on WACC K Bell Jewelers whishes

P9-12) The effect of tax rate on WACC. K. Bell Jewelers whishes to explore the effect on its cost of captial of the rate at which the company pays taxes. The firm wishes to maintain a captial structure of 40% debt, 10% preferred stock, and 50% common stock. The cost of financing with retained eariings is 10%, the cost of preferred stock financing is 8%, and the before-tax cost of debt financing is 6%. Calculate the weighted average cost of capital 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.

Solution

a)

When tax rate is 40%

Weighted average cost of capital = Weight of debt * after tax cost of debt + weight of preferred stock * cost of preferred stock + weight of retained common stock * cost of common stock

WACC = 0.4 * 0.06 * ( 1 - 0.4) + 0.1 * 0.08 + 0.5 * 0.1

WACC = 0.0144 + 0.008 + 0.05

WACC = 0.0724 or 7.24%

b)

When tax rate is 35%

WACC = 0.4 * 0.06 * ( 1 - 0.35) + 0.1 * 0.08 + 0.5 * 0.1

WACC = 0.0156 + 0.008 + 0.05

WACC = 0.0736 or 7.36%

c)

When tax rate is 25%

WACC = 0.4 * 0.06 * ( 1 - 0.25) + 0.1 * 0.08 + 0.5 * 0.1

WACC = 0.018 + 0.008 + 0.05

WACC = 0.076 or 7.6%

d)

When Income tax rate decraeses, debt becomes costlier and so weighted average cost of capital increases. This happens because the company gets tax deduction for the interest paid to debtholders. Therefore when the tax rate decraeses, weighted average cost of capital increases and vice versa.