Investing and Financial Markets
Taxes and Tax Preparation

What portion of the WACC calculation is impacted by the marginal taxes?

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2008-09-02 16:03:36
2008-09-02 16:03:36

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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