How would each of the follwoing scenarios affect a firm\'ss cost of debt Rd(1-T)

Question

How would each of the follwoing scenarios affect a firm'ss cost of debt Rd(1-T); its cost of equiry, Rs and its WACC? Indicate with a plus a minus or a zero if the factor would raise, would lower, or would have an indeterminable effect on the item in question. Asssssssume for eaaach answer that other things are held constant evene though in some instances this would probably not be true. Be prepared to justify your answer

Effet on

Rd(1-T)                           Rs                       WACC

a. The coroprate tax rate is lowered.

b. The Federal Reserve tightens credit

c. The firm uses more debt that is, it increases its debt/assets ratio

d. The dividend payout ratio is increased

e. The firm doubles the amount of capital it raises during the year.

f. The firm expands into a risky new area.

g. The firm merges with another firm whose earnings are countercyclical both to those of the first firm and the stock market.

h. The stock market falls drastically and the firm's stock price falls along with the rest.

i. Investors become more rick averse.

J. The firm is an electric utility with a large investment in nuclear plants. Several states are considering a ban on nuclear power generation.

Explanation / Answer

As large American companies continue to lobby Congress for tax reform that would lower their tax rates, a study of historical corporate tax rates found that they are in fact paying at rates roughly half of those they paid decades ago.

The Washington Post analyzed 30 large companies listed on the Dow Jones Industrial Average %u2014 companies like McDonalds, Microsoft, and Exxon Mobil %u2014 and found that their tax rates have fallen even as profits have risen, thanks in large part to tax laws that provide incentives to store overseas profits in offshore tax havens. Many of the companies, the Post found, are paying rates less than half what they paid in the 1960s and 1970s, and most of the 30 have vastly reduced their rates in that time:

A Washington Post analysis of data from S&P Capital IQ, a research firm, found that in the late 1960s and early 1970s, companies listed on the current Dow 30 routinely cited U.S. federal tax expenses that were 25 to 50 percent of their worldwide profits. Now, most are reporting less than half that share. [...]

Out of all the firms in the Dow 30, 22 have seen a drop of more than 10 percentage points between the oldest year for which data are available and the most recent year.

American tax law allows companies to shield foreign profits from taxation until they are brought back to the United States, and corporations have happily obliged. The largest 83 corporations moved $166 billion overseas in 2012 alone, bringing their total to $1.46 trillion, and most of it, according to a Congressional Research Service study, was kept in tax havens like Bermuda, the Cayman Islands, Luxembourg, and Ireland. As a result, they have seen huge reductions in tax rates: McDonald%u2019s, for example, saw its tax rate plunge from 37 percent in 1973 to 14 percent in 2012.

Corporate profits hit a 60-year high in 2011, right as the effective corporate tax rate hit a 40-year low. America%u2019s largest companies, in fact, haven%u2019t paid the full corporate tax rate in 45 years, and 26 have avoided taxation altogether for the past four years. At the same time, business leaders have lobbied Congress to reform the corporate tax code by adopting a territorial tax system that would exempt most foreign profits from American taxation, making it even easier for the companies to shift profits, investments, and jobs overseas.

One analysis found that a territorial system would lead to the creation of 800,000 jobs in other countries that otherwise could have been created in the United States. An alternative tax reform that closes corporate loopholes that lead to the offshoring of profits and jobs wouldn%u2019t bring the tax rate back to historical levels, but it would still generate roughly $168 billion in revenue over the next decade.

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