Sensitivity Analysis - WACC

Burkamp's picture
Rank: Baboon | 102

In a WACC sensitivity analysis in my textbook the drivers sensitized for are 'debt-to-total capitalization' and 'pre-tax cost of debt'.

What is the reason for using pre-tax cost of debt rather than just cost of debt? Further, is that just one of several possibilities to sensitize WACC, or are these the drivers commonly used?

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Dec 14, 2018

In the actual WACC formula you use after tax cost of debt because bond interest is tax deductible

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Dec 15, 2018

1 - Tax rate

Dec 14, 2018

Interest is a tax-deductible expense, so a company taking on debt (be it a bond or a debenture) creates a tax shield. Tax shields allow companies to reduce income taxes due as allowable deductions (as per the taxation act). This obviously affects cash flows and subsequently, overall value of the entity in question.

Hence the after-tax cost of debt = pre-tax cost of debt * (1 - taxation rate) is used to capture this interest tax shield.

Dec 15, 2018

Changing pretax cost of debt should have a linear impact on post-tax cost of debt, so same difference...

When you price debt for corporates, it's on a pretax basis. Every company has slightly different tax situation, but the coupon is what it is. Think they're just showing it this way here so you can eyeball the pretax cost of debt and have some frame of reference (... yeeshhhh 9% really hurts valuation)

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Dec 15, 2018
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