Investing and Financial Markets

Taxes and Tax Preparation

Top Answer

The WACC is determined from two separate calculations, one based
on the cost of equity and the other on the cost of debt. The 'cost
of debt' calculation can take into account the tax rate. The whole
calculation uses five variables, and the tax rate serves to reduce
the 'cost of debt' percentage. The bigger the tax rate, the greater
the impact on the cost of debt. The lower the tax rate, the smaller
the impact. However, as there are five variables in the whole
calculation, and the sums, magnitude and significance will differ
from company to company, the only way to determine the impact of
tax rates (marginal or otherwise) in a particular case is to do
comparative calculations of WACC, one with, and the other without
the tax rate element. By calculating the difference between the two
results, one can determine the precise impact/significance of
including/excluding tax considerations when calculating WACC for a
particular corporate scenario. In a company with a large cost of
debt and a small cost of equity, the effect of the rate of tax (in
the WACC calculation) will be higher than that in a company with a
high cost of equity and a low cost of debt. In other words, the
relative weighting of the 'cost of debt' against the 'cost of
equity' is an important influencing element in the WACC
computation. **N.B.** When calculating WACC, the 'after-tax'
percentage (i.e. *with* due allowance for the tax rate,) is
generally considered to be a better indicator of the true WACC for
a particular company than omitting tax liabilities entirely from
the calculations.

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