WACC = cost of debt * (1 - tax rate) * weight (D) + cost of equity * weight (E)
Why does the equity part of the WACC (i.e., the second part of the above formula) not adjusted for the tax rate?
In another word:
If we have already adjusted FCF for the tax (FCF includes the impact of tax by using EBIT * (1 - tax rate)), then why are we again adjusting the cost of debt for the tax?
Rather than getting into somewhat complex mathematics let me try it in a 1-2-3 manner:
Suppose you want to float a company. The equity portion that you will be bringing in is completely yours … right ? Your equity ( and whatever has accrued to it ) is after any tax liability. So the required return associated with it must also be post tax( FCFE is the residual of FCFF).
What happens to the debt portion. You want to raise $10000000000 thru debt. You get the whole right ?( of course after deducting the duties etc but not the tax or more precisely the income tax). Whatever interest you pay on the same is again tax deductible. Hence the only burden to your debt is the after tax portion.
Hope the matter is clear
Sorry, but I didn’t understand your statement: “Your equity ( and whatever has accrued to it ) is after any tax liability”. Does it mean that the company has to pay on the raised amount through equity but not through debt?
One reason I could think of: interest will be cash-out every year (a fair assumption) and will be taxed at the same time. It is not the case with equity. Based on this assumption, neither the shareholders nor the bondholders (on the principal amount) will be liable to pay tax (at that particular time).
A big assumption in the above statement is that the shareholders will never liquidate his/her position in the company.
Let me know your thought on this.
You did not read the “when you float the company part “. How did you get your equity then ? All the proceeds must have been post tax only … right?
Most of the countries have done away with double taxation As far as long term shareholders returns are concerned. So yes… when you raise capital via equity route it is just that AT THE FORMATION STAGE. IPOs or FPOs on the other hand are with premium over the face value of equity … hence a capital gain.
Where is the confusion ?
I think the statement is not right. Company does not pay any tax on the fund raised either through equity or debt.
Seriously what is your question ? It should have been crystal clear by now.
Interest expense reduces taxable income (i.e. interest is tax deductible), resulting in lower income taxes. The tax savings from the use of debt is reflected through an adjustment on the cost of debt.
Common dividends are not tax deductible, hence cost of equity does not need to be adjusted for tax in WACC formula.