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P9-12 Bell Jewelers-rate of taxation and WACC

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% d. Describe the relationship between changes in the rate of taxation and the weighted average cost of capital.

Solution :

a.

WACC = (0.40)(6%)(1 − 0.40) + (0.10)(8%) + (0.50)(10%)

WACC = 1.44% + 0.8% + 5%

WACC = 7.24%

b.

WACC = (0.40)(6%)(1 − 0.35) + (0.10)(8%) + (0.50)(10%)

WACC = 1.56% + 0.8% + 5%

WACC = 7.36%

c.

WACC = (0.40)(6%)(1 − 0.25) + (0.10)(8%) + (0.50)(10%)

WACC = 1.80% + 0.80% + 5%

WACC = 7.60%

d.

The weighted average cost of capital is inversely proportional to the tax rate i.e. as the tax rate declines the tax shield also reduces and resultantly the WACC rises.

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