Explain why the cost of debt is tax-affected but the cost of equity is not.
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The answer
The cost of debt is tax-affected because interest payments are tax-deductible, while returns to equity such as dividends and buybacks are not. For every dollar of interest a company pays, it saves its marginal tax rate in taxes it would otherwise owe, so the true net cost is lower than the stated rate. That after-tax cost, the pre-tax yield times one minus the tax rate, is what enters WACC.
The tax shield belongs there because WACC discounts unlevered free cash flow and needs to capture the benefit of deductible interest. The cost of equity, on the other hand, is not tax-affected because dividends are paid from after-tax profits and provide no deduction. I would always use the after-tax cost of debt in the WACC and leave the cost of equity unadjusted.
DCF timeline
| Line item | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|
| Free cash flow | 50 | 54 | 58 | 63 | 68 |
| PV of free cash flow | 45 | 45 | 44 | 43 | 42 |
| Terminal value (Year 5 exit) | 1,001 |
| PV of terminal value | 621 |
| Implied enterprise value | 840 |
Also asked as
- Write out the full WACC formula and define every term. Which two terms represent the market's forward-looking view versus a contractual/historical figure?
- Why do we use the yield to maturity on a company's debt rather than its coupon rate when estimating the cost of debt?
- Why should capital structure weights reflect the company's target structure rather than its current balance sheet, and give an example of when the two would diverge.
- A company has no public debt. Describe, step by step, how you would estimate its cost of debt using the synthetic credit rating approach.
- Explain the circularity problem that arises if you try to solve for a company's mathematically optimal (WACC-minimizing) capital structure, and how practitioners work around it.
- A company's EBIT is $120mm and interest expense is $24mm, mapping to a synthetic single-A rating with a 1.2% spread over a 4.0% risk-free rate. Tax rate is 24%. Compute the after-tax cost of debt.
- A company has market equity of $2,400mm, market debt of $800mm, cost of equity 13%, pre-tax cost of debt 5.5%, and a marginal tax rate of 25%. It also has $1bn of NOLs fully shielding taxable income for the next two years only. Compute WACC for year 1 and for year 3, and explain why they differ.
- A company just issued $500mm of debt to fund an acquisition, taking D/V from a historical 20% to a current 50%. Peers run at 25% D/V long-run. The company plans to delever back to 25% over four years. Explain, with reference to both Re and Rd, why using today's 50% D/V weight with today's (higher-leverage) beta would be doubly wrong for a DCF used to value the company on a going-concern, steady-state basis.
- A company's bonds trade at 85 cents on the dollar with a 5% coupon and 4 years to maturity (assume annual coupons, par value $100, for simplicity ignore compounding intricacies and estimate the approximate current yield plus a rough YTM approximation). Explain qualitatively why 5% would be the wrong number to use in WACC and what the price signal tells you about the direction of the error.
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The rest of this topic
The DCF: cash flow, discount rate, terminal value