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Flura [38]
3 years ago
8

Westbrook's Painting Co. plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannual

ly. The company's marginal tax rate is 25%, but Congress is considering a change in the corporate tax rate to 15%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted
Business
1 answer:
xeze [42]3 years ago
4 0

Answer:

The component cost of debt used to calculate the WACC will change by <u>0.70%</u> if the new tax rate was adopted.

Explanation:

This can be calculated using the formula for calculating the component cost of debt used to calculate the WACC as follows:

CD = WD * PCD * (1 - t) ........................ (1)

Where;

CD = Component of cost of debt in WACC

WD = Weight of debt

PCD = Pretax cost of debt

t = tax rate

Note: Since information is provided for only the 20-year noncallable bond in the question, we assume that WD is 100% for simplicity purpose.

We can therefore proceed as follows:

<u>a. CD When tax rate is 25%</u>

Based on equation (1) and the assumption in the note, we have:

CD when t is 25% = Component of cost of debt in WACC = ?

WD = Weight of debt = 100%

PCD = Pretax cost of debt = 7%

t = tax rate = 25%

Substituting into equation (1), we have:

CD when t is 25% = 100% * 7% * (1 - 25%) = 5.25%

<u>b. CD When tax rate is 15%</u>

Based on equation (1) and the assumption in the note, we have:

CD when t is 15% = Component of cost of debt in WACC = ?

WD = Weight of debt = 100%

PCD = Pretax cost of debt = 7%

t = tax rate = 15%

Substituting into equation (1), we have:

CD when t is 15% = 100% * 7% * (1 - 15%) = 5.95%

c. the WACC change if the new tax rate was adopted

Change in WACC = CD when t is 15% - CD when t is 25% = 5.95% - 5.25% = 0.70%

Therefore, the component cost of debt used to calculate the WACC will change by <u>0.70%</u> if the new tax rate was adopted.

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