To understand the advantage of debt capital from a tax perspective in the United States, determine the before-tax and approximated after-tax weighted average costs of capital if a project is funded 40%–60% with debt capital borrowed at 9% per year. A recent study indicates that corporate equity funds earn 12% per year and that the effective tax rate is 35% for the year.
What will be an ideal response?
Before-taxes:
WACC = 0.4(9%) + 0.6(12%) = 10.8% per year
After-tax approximation: Insert Equation [10.4] into the before-tax WACC relation.
After-tax WACC = (equity)(equity rate) + (debt)(before-tax debt rate)(1–Te)
= 0.4(9%) + 0.6(12%)(1-0.35)
= 8.28% per year
The tax advantage reduces the WACC from 10.8% to 8.28% per year
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