Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy(^530) 15. Cost of Capital © The McGraw−Hill
Companies, 2002
Taxes and the Weighted Average Cost of Capital
There is one final issue we need to discuss. Recall that we are always concerned with af-
tertax cash flows. If we are determining the discount rate appropriate to those cash
flows, then the discount rate also needs to be expressed on an aftertax basis.
As we discussed previously in various places in this book (and as we will discuss
later), the interest paid by a corporation is deductible for tax purposes. Payments to
stockholders, such as dividends, are not. What this means, effectively, is that the gov-
ernment pays some of the interest. Thus, in determining an aftertax discount rate, we
need to distinguish between the pretax and the aftertax cost of debt.
To illustrate, suppose a firm borrows $1 million at 9 percent interest. The corporate
tax rate is 34 percent. What is the aftertax interest rate on this loan? The total interest bill
will be $90,000 per year. This amount is tax deductible, however, so the $90,000 inter-
est reduces the firm’s tax bill by .34 $90,000 $30,600. The aftertax interest bill is
thus $90,000 30,600 $59,400. The aftertax interest rate is thus $59,400/1 million
5.94%.
Notice that, in general, the aftertax interest rate is simply equal to the pretax rate mul-
tiplied by 1 minus the tax rate. [If we use the symbol TCto stand for the corporate tax
rate, then the aftertax rate that we use can be written as RD(1 TC).] For example,
using the numbers from the preceding paragraph, we find that the aftertax interest rate
is 9% (1 .34) 5.94%.
Bringing together the various topics we have discussed in this chapter, we now have
the capital structure weights along with the cost of equity and the aftertax cost of debt.
To calculate the firm’s overall cost of capital, we multiply the capital structure weights
by the associated costs and add them up. The total is the weighted average cost of cap-
ital (WACC).
WACC (E/V) RE(D/V) RD(1 TC) [15.6]
This WACC has a very straightforward interpretation. It is the overall return the firm
must earn on its existing assets to maintain the value of its stock. It is also the required
return on any investments by the firm that have essentially the same risks as existing op-
erations. So, if we were evaluating the cash flows from a proposed expansion of our ex-
isting operations, this is the discount rate we would use.
If a firm uses preferred stock in its capital structure, then our expression for the
WACC needs a simple extension. If we define P/Vas the percentage of the firm’s fi-
nancing that comes from preferred stock, then the WACC is simply:
WACC (E/V) RE(P/V) RP(D/V) RD(1 TC) [15.7]
where RPis the cost of preferred stock.
502 PART SIX Cost of Capital and Long-Term Financial Policy
To get a feel for actual,
industry-level WACCs, visit
valuation.ibbotson.com.
weighted average cost
of capital (WACC)
The weighted average of
the cost of equity and
the aftertax cost of debt.
Calculating the WACC
The B. B. Lean Co. has 1.4 million shares of stock outstanding. The stock currently sells for
$20 per share. The firm’s debt is publicly traded and was recently quoted at 93 percent of face
value. It has a total face value of $5 million, and it is currently priced to yield 11 percent. The
risk-free rate is 8 percent, and the market risk premium is 7 percent. You’ve estimated that
Lean has a beta of .74. If the corporate tax rate is 34 percent, what is the WACC of Lean Co.?
We can first determine the cost of equity and the cost of debt. Using the SML, we find that
the cost of equity is 8% .74 7% 13.18%. The total value of the equity is 1.4 million
$20 $28 million. The pretax cost of debt is the current yield to maturity on the outstanding
debt, 11 percent. The debt sells for 93 percent of its face value, so its current market value is
EXAMPLE 15.4