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Question of the Week - Corporate Finance

Des Moines, IA, USAPosts: 211 Sr Associate
edited January 2015
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:

Question of the Week - Corporate Finance 65 votes

Increases by 0.10%
64%
Decreases by 0.10%
24%
Remains the same
10%

• Des Moines, IA, USAPosts: 211 Sr Associate
Increases by 0.10%

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.