P9-12 The effect of tax rate on WACC K. Bell Jewelers wishes to explore the effe
ID: 2614448 • Letter: P
Question
P9-12 The effect of tax rate on WACC K. Bell Jewelers wishes to explore 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 preferred 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% /o d. Describe the relationship between changes in the rate of taxation and the weighted average cost of capital.Explanation / Answer
Solution:-
WACC can be calculated as follows:-
=Kd(1-tax)*Wd+Kp*Wp+Ke*We
Where,
Kd= Before tax cost of debt = 6%
Wd= Weight of debt = 0.40
Kp = Cost of preferred stock = 8%
Wp= Weight of preferred stock = 0.10
Ke= Cost of common stock = 10%
We= Weight of common stock = 0.50
a) WACC when tax rate is = 40%
From the above formula :-
WACC =Kd(1-tax)×Wd+Kp×Wp+Ke×We
Substituting the values we get ,
WACC= 6×(1-40%)×(0.40)+8×0.10+10×0.50
WACC= 1.44+0.80+5
WACC=7.24%
b) WACC when tax rate is = 35%
From the above formula :-
WACC =Kd(1-tax)×Wd+Kp×Wp+Ke×We
Substituting the values we get ,
WACC= 6×(1-35%)×(0.40)+8×0.10+10×0.50
WACC= 1.56+0.80+5
WACC=7.36%
c) WACC when tax rate is = 25%
From the above formula :-
WACC =Kd(1-tax)×Wd+Kp×Wp+Ke×We
Substituting the values we get ,
WACC= 6×(1-25%)×(0.40)+8×0.10+10×0.50
WACC= 1.80+0.80+5
WACC=7.60%
d) There is the inverse relation between the tax rate and the t after WACC. Meaning when tax rate increases after tax WACC decreases and vice versa.
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