P9-12 The effecet of tax rate on WACC K. Bell Jewelers wishes to explore the eff
ID: 2614489 • Letter: P
Question
P9-12 The effecet 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, of financing with retained earnings is 10%, the cost of preferred stock financing is 8 and the 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 10% preferred stock, and 50% common stock. The cost %, efore-tax cost of debt financing is 6%. Calculate the weighted average cost of weighted average cost of capital.Explanation / Answer
Debt Proportion = D = 0.4, Preferred Stock Proportion = P = 0.1 and Common Stock Proportion = E = 0.5
Cost of Retained Earnings (Common Stock) = ke = 10 %, Cost of Preferred Stock = kp = 8 % and Before-Tax Cost of Debt = kd = 6 % and let Tax Rate be t
Therefore, WACC = kd x (1-t) x D + kp x P + ke x E
(a) t=40 % , WACC = 6 x (1-0.4) x 0.4 + 8 x 0.1 + 10 x 0.5 = 7.24 %
(b) t=40 % , WACC = 6 x (1-0.35) x 0.4 + 8 x 0.1 + 10 x 0.5 = 7.36 %
(c) t=40 % , WACC = 6 x (1-0.25) x 0.4 + 8 x 0.1 + 10 x 0.5 = 7.6 %
(d) As the tax rate increases the factor (1-t) decreases which in turn lowers the after-tax cost of debt. The decreasing after tax cost of debt lowers the overall WACC. Therefore, Increasing tax rate -> Decreasing (1-t) -> Decreasing after-tax cost of debt -> Decreasing overall WACC.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.