The weighted average cost of capital formula (WACC) shown below is the accepted

Question

The weighted average cost of capital formula (WACC) shown below is the accepted method of computing a firm’s cost of capital. WACCadj = E x Re + PS x Rps + D x Rd X (1 - Tc) V V V Where: E = Equity dollars of financing PS = Preferred Stock dollars of financing D = Debt (bond) dollars of financing V = Total financing = E +PS +D Re = % Cost of Common Stock Rps = % Cost of Preferred Stock Rd = % Cost of Debt after tax Tc = Effective tax rate After reviewing this formula, your reading assignments and the instructor’s PowerPoint presentation, in a one paragraph posting, answer the following questions and provide a short supporting rationale for each answer. The answer does not require a quantitative solution What impact will the following company actions have on the company’s weighted average cost of capital (WACC): 1. An Increase in the company’s corporate tax rate? 2. An Increase in the company’s flotation cost? 3. An increase in the company’s dividend? Can you demonstrate your answer mathematically?

Explanation / Answer

Corporate tax rate is used to compute after tax cost of debt.

Kd = Rd x (1-t)

Any increase in corporate tax rate will decrease the cost of debt (kd) and thus cost of capital for the firm will decrease.

Floatation cost increases the cost of individual sources of capital as due to floatation cost less amount of capital is actually received by the firm. This will increase overall cost of capital of the firm.

Ke = D1/ (P-f) + g

Here f is floatation cost which will reduce the denominator.

Dividend is used to compute cost of equity for the firm.

Ke = D1/ (P-f) + g

D1 which is expected dividend per share is the numerator, so any increase in numerator will increase the cost of equity for the firm. Increase in cost of equity will ultimately increase the cost of capital of the firm.

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