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TAXES AND THE WEIGHTED-AVERAGE COST OF CAPITAL

Thus far in this section our examples have ignored taxes. Taxes are important because interest payments are deducted from income before tax is calculated. Therefore, the cost to the company of an interest payment is reduced by the amount of this tax saving. The interest rate on Geothermal`s debt is rdebt = 8 percent. However, with a corporate tax rate of Tc = .35, the government bears 35 percent of the cost of the interest payments.

The government doesn`t send the firm a check for this amount, but the income tax that the firm pays is reduced by 35 percent of its interest expense. Therefore, Geothermal`s after-tax cost of debt is only 100 Ј 35 = 65 percent of the 8 percent pretax cost:

After-tax cost of debt = pretax cost _ (1 Ј tax rate) = rdebt _ (1 Ј Tc) = 8% ГЧ (1 Ј .35) = 5.2%

We can now adjust our calculation of Geothermal`s cost of capital to recognize the tax saving associated with interest payments: Company cost of capital, after-tax = (.3 ГЧ 5.2%) + (.7 ГЧ 14%) = 11.4%

WEIGHTED-AVERAGE COST OF CAPITAL (WACC) Expected rate of return on a portfolio of all the firm`s securities, adjusted for tax savings due to interest payments.

WHAT IF THERE ARE THREE (OR MORE) SOURCES OF FINANCING?

We have simplified our discussion of the cost of capital by assuming the firm has only two classes of securities: debt and equity. Even if the firm has issued other classes of securities, our general approach to calculating WACC remains unchanged. You simply calculate the weighted-average after-tax return of each security type.

For example, suppose the firm also has outstanding preferred stock. Preferred stock has some of the characteristics of both common stock and fixed-income securities. Like bonds, preferred stock promises to pay a given, usually level, stream of dividends. Unlike bonds, however, there is no maturity date for the preferred stock. The promised dividends constitute a perpetuity as long as the firm stays in business. Moreover, a failure to come up with the cash to pay the dividends does not push the firm into bankruptcy. Instead, dividends owed simply cumulate; the common stockholders do not receive dividends until the accumulated preferred dividends have been paid. Finally, unlike interest payments, preferred stock dividends are not considered tax-deductible expenses.

How would we calculate WACC for a firm with preferred stock as well as common stock and bonds outstanding? Using P to denote preferred stock, we simply generalize the formula for WACC as follows:

Let`s try an example to make this concrete

Weighted-Average Cost of Capital for Executive Fruit

Unlike Geothermal, Executive Fruit has issued three types of securities ¤debt, preferred stock, and common stock. The debtholders require a return of 6 percent, the preferred stockholders require an expected return of 12 percent, and the common stockholders require 18 percent. The debt is valued at $4 million (D = 4), the preferred stock at $2 million (P = 2), and the common stock at $6 million (E = 6). The corporate tax

rate is 35 percent. What is Executive`s weighted-average cost of capital? Don`t be put off by the third security, preferred stock. We simply work through the following three steps.

Step 1. Calculate the value of each security as a proportion of the firm`s value. Firm value is V = D + P + E = 4 + 2 + 6 = $12 million. So D/V = 4/12 = .33; P/V = 2/12 = .17; and E/V = 6/12 = .5.

Step 2. Determine the required rate of return on each security. We have already given you the answers: rdebt = 6%, rpreferred = 12%, and requity = 18%.2

Step 3. Calculate a weighted average of the cost of the after-tax return on debt and the return on the preferred and common stock: