In the weighted average cost of capital formula, the after-tax cost of debt is u
ID: 1176032 • Letter: I
Question
In the weighted average cost of capital formula, the after-tax cost of debt is used instead of the before-tax cost of debt. However, no such adjustment is made to the cost of equity. Are you surprised by this different tax handling of debt versus equity? Why or why not? If a corporation borrowed all of the money for its project at the risk-free rate, does that mean that the project’s cost of capital is the risk-free rate? When calculating the weighted average cost of capital, would it matter more if book values instead of market values were used for equity instead of debt? Please explain.
Explanation / Answer
In caluclation of WACC after tax cost of debt is considered because interest payment on debt is a tax deductable expense and which reduces the cost of debt while dividend on common stock is not tax deductable so there is after tax cost of equity is considered for calculation of WACC.
Yes if entire project is financed from risk free rate of return in this case WACC would be risk free rate because 100% capital is financed from risk free source of finance
Yes use of book value or market value increase or decreases the overall cost of capital, it is better to use market value weights because these securities are tradable and their value keep on changing so it is preferred to calculate WACC using market value weights.