Question of the Week – Corporate Finance

Question

Komelech Design is an advertisement agency, with 40% of its financing debt, 40% equity, and 20% preferred stock. Komelech's cost of preferred stock is 5%, cost of equity is 9%, and before-tax cost of debt is 4%. If the marginal tax rate decreases from 40% to 35%, it can be best described that Inturnal's weighted average cost of capital:

 	Increases by 0.10%
 	Decreases by 0.10%
 	Remains the same

AdaptPrep · Answer

The formula to use is:

WACC = w_d * r_d * (1 – t) + w_p * r_p + w_e * r_e

And we have:

w_d = 0.4

w_p = 0.2

w_e = 0.4

r_d = 0.04

r_p = 0.05

r_e = 0.09

t = 0.4

So, the WACC before the change in tax rate is:

WACC = 0.4 * 0.04 * (1 – 0.4) + 0.2 * 0.05 + 0.4 * 0.09 =
5.56%At the new rate, we have t = 0.35, so the WACC after the
change in tax rate is:

WACC = 0.4 * 0.04 * (1 – 0.35) + 0.2 * 0.05 + 0.4 * 0.09 =
5.64%

The WACC increases by 0.08%.

Note that we don't need to do this entire calculation twice
if we didn't want to, since the only variable is the change in the debt
component. All we needed to do is calculate:

Change in WACC = w_d * r_d * (t_old – t_new) = 0.4 * 0.04 *
(0.40 – 0.35) = 0.08%.

We know that this is an increase because taxes decrease the
cost of capital, so a tax cut would increase the cost of capital.