Question

Westbrook's Painting Co. plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 30.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

a. 0.57%
b. 0.63%
c. 0.70%
d. 0.77%
e. 0.85%

Answer 1

0.7%

Step-by-step explanation:

Because the company this bond at par value so the yield-to-maturity (used as proxy for pre-tax cost debt) is equal to the coupon rate of 7%. The weighted average cost of capitals (WACC) is stated as below:

WACC = Weight of equity x Cost of equity + Weight of debt x Pre tax cost of debt x (1 - Tax rate%)

So, when the tax rate decrease from 40% to 30%, component cost of debt in WACC will change by (40% - 30%) x 7% = 0.7%