Hi Guys,
I have a question about calculating WACC.
I know the formula is
WACC = (E/E+D+P × re) + (D/E+D+P × (1 − t) × rd) + (P/E+D+P × rp)
I forgot why you multiply (1-t) times Debt. Is it because you do not pay taxes on issuing debt or something like that?
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Interest on debt is tax deductible.
It is because interest expense on debt expense is tax exempt (i.e., is deducted before taxes). So if you pay $10 in interest expense and $10 in equity dividends and have a 40% tax rate, the $10 in interest payment only costs you $6, (because you pay $4 less in taxes) whereas the $10 in dividends cost you the whole $10.
I am still confused.
So why do you multiply the percentage of debt by (1-t)?
.
look a booth's example. 1-t = 1-(.4*10) = 1-4 = $6
It's percentage of debt x COST of debt (interest expense) x 1-t. If you didn't do the 1-t you wouldn't be considering the tax deduction the company gets.
So for the debt portion you do the (D/(D+E) * interest expense * (1-t)
The debt in the wacc equation is the before tax cost of debt.
(1-t) D will give you the after tax cost of debt which is what you need. The equity in the equation is already the after tax value so thats why they are not multiplied by 1-t.
ex. If you got a $1000 check and the tax rate in NYC is 30% then to get your after tax income, you multiply by 1-t.
1000(1-.30) = $700
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