Question

Recently, the government decided to decrease corporate tax from 35% to 21%. A firm's cost of equity is 10% and cost of debt is 3%. The firm continues to finance its operation by 40% equity and 60% bond. What are WACC before and after the tax reform, respectively? Assume that the costs of equity and debt, and the firm's capital structure did not change after the reform.

Answer 1

The WACC before tax reform was calculated to be 5.17%, and after the reform, it was calculated to be 5.422%, given the costs of equity and debt as well as the firm's capital structure.

Step-by-step explanation:

The student's question pertains to the calculation of the Weighted Average Cost of Capital (WACC) before and after a corporate tax decrease from 35% to 21%. The firm uses a financing structure of 40% equity and 60% debt with the costs of equity and debt given as 10% and 3%, respectively. The WACC formula is:

WACC = E/V * Re + D/V * Rd * (1-Tc)

Where:

• E = Market value of equity
• V = Total market value of equity and debt
• Re = Cost of equity
• D = Market value of debt
• Rd = Cost of debt
• Tc = Corporate tax rate

Before the tax reform:

WACC = 0.40 * 0.10 + 0.60 * 0.03 * (1-0.35) = 0.04 + 0.0117 = 0.0517 or 5.17%

After the tax reform:

WACC = 0.40 * 0.10 + 0.60 * 0.03 * (1-0.21) = 0.04 + 0.01422 = 0.05422 or 5.422%

The WACC before tax reform was 5.17%, and after the reform, it is 5.422%.