Corporations allowed to deduct interest payments as an expense. Corporations all
ID: 2758606 • Letter: C
Question
Corporations allowed to deduct interest payments as an expense. Corporations allowed to deduct dividend payments to stockholders as an expense. The differential tax treatment of interest payments and dividend payments encourages firms to use in their capital structure. Debt financing is expensive than common or preferred stock financing. Industrialization Automation Co. currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firm's unlevered beta is 1.1, and its cost of equity is 13.35%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 13.35%. The risk-free rate of interest (r_RF) is 4%, and the market risk premium (RP) is 8.5%. Industrialization Automation Co.'s marginal tax rate is 35%. Industrialization Automation Co. is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table.Explanation / Answer
Corporations are allowed to deduct interest payments as expense. Corporations are not allowed to deduct dividend payment to stock holders as an expense. The differential tax treatment of interest payments and dividend payments encourages firms to use debt in their capital structure. Debt financing is less expensive than common or preferred stock financing.
Before Cost of D/A E/A D/E Bond tax cost Levered Equity Ratio Ratio Ratio rating of debt beta Ke WACC 0.0 1.0 0.00 1.10 13.35 13.35 0.2 0.8 0.25 A 8.4 1.28 14.88 13.00 0.4 0.6 0.67 BBB 8.9 1.58 17.43 12.77 0.6 0.4 1.50 B 11.1 2.17 22.44 13.31 0.8 0.2 4.00 C 14.3 3.96 37.66 14.97 Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)) Cost of equity as per CAPM = Rf + B(Rm - Rf)