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.
