11: Risk and Capital Budgetinginterest payments to bondholders are tax-deductible. This results in a lower cost of debt. For example, a
company with a before-tax cost (rd) of debt of 7% and a tax rate (Tc) of 30% would have an after-tax cost
of debt (rd × (1 – Tc)) of 4.9% (7.0% × (1 – 0.30)). The tax-deductibility of interest lowers a company’s
tax payments, and therefore effectively reduces its cost of debt. So the opportunity to deduct interest
payments reduces the after-tax cost of debt and changes the basic WACC formula:
WACC when interest on debt is tax-deductible:
Eq. 11.4 = ()
−+
+
WACC
D
DETr
E
DE(^1) cd re
where Tc is the marginal corporate tax rate.
Fortunately, the three main lessons listed previously do not change when we add taxes to the picture.
Only the calculations change. When a company is making an ‘ordinary’ investment, it can use Equation
11.4 to determine its after-tax WACC, which serves as the discount rate in NPV calculations.
This reduction for a company of the cost of debt because it is tax-deductible gives rise to a concept
called the tax shield. As the name implies, the ability to make an interest deduction against income before
taxation is imposed protects, or shields, the corporate profits from taxation. In fact, this effect can be
significant enough to raise the value of a company that employs debt in its capital funding as opposed to
the value of a company that is financed only from equity (which is not tax-deductible). We shall explore
this tax shield effect on value in later chapters when we examine how companies decide on their capital
structures; that is, the balance of debt and equity they use to fund their activities.
In some countries, including Australia and New Zealand, there is a further tax implication that
follows from the ‘dividend imputation tax’ regime run in those nations. We examine this more fully in
section 13-3c of Chapter 13, but note here that the impact of dividend imputation – the process of
allowing individual investors receiving dividends to deduct tax already paid by companies before those
individuals pay their personal taxes on dividends – is to offset the after-tax required return to equity that
is pushed up by leverage, and thereby reduce the overall cost of capital to the company. In effect, under
a regime of full dividend imputation, the investor in a company is indifferent as to whether she receives
returns on the investment in the form of interest payments on bonds or dividends on shares if they are at
the same rate, because the tax shield gain on bond interest payments is matched by the tax allowances
imputed to the dividend payments.
1 Why is using the cost of equity to discount project cash flows inappropriate when a company uses
both debt and equity in its capital structure?
2 Two companies in the same industry have very different equity betas. Offer two reasons why this
could occur.
3 For a company considering expansion of its existing line of business, why is the WACC, rather than
the cost of equity, the preferred discount rate if the company has both debt and equity in its capital
structure?
4 The cost of debt, rd, is generally less than the cost of equity, re, because debt is a less risky security. A naïve
application of the WACC formula might suggest that a company could lower its cost of capital (thereby
raising the NPV of its current and future investments) by using more debt and less equity in its capital
structure. Give one reason why using more debt might not reduce a company’s WACC, even if rd < re.
CONCEPT REVIEW QUESTIONS 11-1
tax shield
The ability to make an interest
deduction against income
before taxation is imposed
protects, or shields, the
corporate profits from taxation