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Which portion of the WACC calculation is impacted by taxes?


How can a company reduce its cost of capital? How is WACC used in financial planning to optimize capital structure?

1. Debt. side. WACC is made up of two sides: debt and equity. The debt side is the cost of debt adjusted for the tax shield benefit. K(d) = Interest Expense/Market Value of Debt x (1-t).

The equity side is calculated as K(e) = [Beta x (R(m) - R(f)] + R(f) where R(m) = Long term market return, R(f) = risk free rate and Beta is the raw historical beta (adjusted for any forward looking factors). Tax is already implicitly factored into the action of the stock to derive Beta, but as you can see it is not explicitly in the calculation.

2. A company can reduce its cost of capital by doing one of the following things:
1) Using a higher percentage of debt versus equity (since debt is usually less expensive equity). This can be done by a) issuing more debt and b) buying back equity
2) Lower the forward-looking beta (e.g. exiting risk businesses, entering into lower risk businesses).
3) Reducing the interest rate on debt (e.g. refinancing debt)

3. WACC is the enterprise-wide cost of financing, which is used to calculate the net present value of the entire firm. In theory, a firm maximizes its NPV by accepting all project that have a positive NPV (i.e. returns higher than the WACC) and turning down the rest. In the real world companies don't have infinite opportunities, so it helps prioritize which projects a company should undertake. It also helps managers to think like owners - specifically to think of equity as expensive financing that shareholders are hoping for benchmark returns - not "free money" that has no impact on the income statement. Source(s): CFA charter holder.
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