Effect of Taxes on Cost of Capital

Taxes significantly impact the weighted average cost of capital (WACC) of a company. However, taxes affect the cost of capital from different sources of capital in different ways.

The Effect of Taxes on Debt

In many tax jurisdictions, interest on debt financing is a deduction made before arriving at a company’s taxable income. You may recall that in the equation used to compute the WACC of a company, the expected before-tax cost on new debt financing, r_d, is adjusted by a factor, (1-t). Multiplying r_d, by the factor (1-t), results in an estimate of a company’s after-tax cost of debt.

An example will help to explain this concept better. If, for example, company XYZ pays $10,000 as interest expense on a  $100,000 debt to bondholders, and the company is subject to a tax rate of 35%, then the cost of debt would be ($10,000) × (1 – 0.35) = $6,500. The cost of debt would not be the entire $10,000 that is paid as interest expense. The reason for this is that a company’s taxable income would be reduced by $10,000, which leads to a reduction in the amount of tax that the company pays by ($10,000) × 35% = $3,500. The before-tax cost of debt for the company would be ($10,000/$100,000) = 10%, while the after-tax cost of debt would be ($6,500/$100,000) = 6.5%.

The Effect of Taxes on Common Equity and Preferred Stock

Taxes do not affect the cost of common equity or the cost of preferred stock. This is the case because the payments to the owners of these sources of capital, whether in the form of dividend payments or return on capital, are not tax-deductible for a company. This explains why in the equation for computing the WACC of a company, no tax adjustment is made for these sources of capital.

Question

Which of the following sources of capital do taxes most likely affect?

1. Debt.
2. Preferred stock.
3. Common equity.

Solution

The correct answer is A.

A company’s before-tax cost of debt is adjusted for taxes to derive the after-tax cost of debt for the company.

A and B are incorrect because taxes do not affect the cost of common equity or the cost of preferred stock.