Types of Financing Methods
Every source of capital has different risks for the company and the investor.... Read More
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, rd, is adjusted by a factor, (1-t). Multiplying rd, 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?
- Debt.
- Preferred stock.
- 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.
Sergio Torrico
2021-07-23
Excelente para el FRM 2
Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé
AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
diana
2021-07-17
So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts.
The fun light-hearted analogies are also a welcome break to some very dry content.
I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
Kriti Dhawan
2021-07-16
A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them.
Thank you ! Grateful I saw this at the right time for my CFA prep.
nikhil kumar
2021-06-28
Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
Marwan
2021-06-22
Great support throughout the course by the team, did not feel neglected
Benjamin anonymous
2021-05-10
I loved using AnalystPrep for FRM.
QBank is huge, videos are great.
Would recommend to a friend
Daniel Glyn
2021-03-24
I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
michael walshe
2021-03-18
Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.