Wacc formula
Since I started my CFA journey from a non-finance background (being a maths addict in secondary/6th form), I always enjoyed trying to understand the "logic" behind why every single minute component of each formula I came across. I never quite understood why the cost of debt component would have taxation rate subtracted, could someone throw more light on why (if at all) a bond issuer would end up spending less on debt servicing as the tax rate goes up. PS: please remind me, is "cost of debt" the coupon or discount rate used in pricing?
Taxation rate isn't subtracted from cost of debt, the inverse of the tax rate is multiplied to cost of debt. Rd x (1-Tc) where Tc is tax rate and Rd is cost of debt. If tax rate increases, lower cost of debt. This is due purely to the fact that interest payments are tax deductible
Could you explain "tax deductibility"?
I live in a place where taxation isn't significant
Essentially, any expense that's above the tax line on the income statement is tax deductible, meaning that it reduces the amount of taxes you pay. Since interest comes before taxes, and lowers your pre-tax income, it is considered tax deductible. The higher interest expense the less taxes you pay. Eg. if I have $100 EBIT and in one scenario I have $10 interest expense and another scenario with $20 interest expense, my pre tax income is going to be $90 and $80 respectively. With a 50% tax rate, your after tax income will be $45 and 40$ respectively. You see how with the higher interest expense scenario you paid less in taxes (even though your net income is lower)?
Cost of debt is YTM
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