When calculating WACC, we only need to calculate the after-tax cost of debt, not the cost of equity. Why ?

Question

BlackTom AI · Accepted Answer

When building the WACC, we weigh components of capital by their costs and adjust the cost of debt for taxes because interest on debt provides a tax shield. This means the after-tax cost of debt is used in the WACC, while the cost of equity is treated without a tax adjustment.

Option 1: 'It's a mistake, we need to calculate after-tax for both cost of debt and equity.' This is inaccurate because the tax deduction applies to interest on debt but not to dividends or equity capital, so the cost of equity does not get an after-tax adjustment in the standard WACC formula.

Option 2: 'None of the answer here is correct' This is incorrect since there is a valid reason related to tax deductibility that explains the distinction between debt and equity costs in WACC, making at least one option true.

Option 3: 'The interest expense paid on the debt is tax deductible, while the dividend payment is not tax deductible. Therefore the cost of equity before tax is equity to the cost of equity after tax' This statement captures the core idea: debt has a tax shield (tax-deductible interest), which reduces after-tax cost, whereas dividends are not tax-deductible at the corporate level, so the equity cost is not adjusted by tax in the same way. The phrasing about equity cost being 'before tax' or 'after tax' reflects the standard treatment that equity costs are considered on an after-tax basis only through other tax effects on investors, not via the business's tax shield.

Option 4: 'Because company is not responsible to pay tax for their shareholders on their received dividends.' This is misleading if interpreted too literally for WACC purposes; while individual shareholders may face taxes on dividends, the primary WACC adjustment is the corporate tax shield on debt. This option oversimplifies and ignores the key mechanism (tax-deductible interest) that drives the after-tax debt cost in WACC.

In summary, the correct reasoning hinges on debt providing a tax shield via deductible interest, while equity distributions (dividends) are not tax-deductible at the corporate level, so only the debt cost is adjusted for taxes in WACC, and the equity cost is treated as-is in the formula.

When calculating WACC, we only need to calculate the after-tax cost of debt, not the cost of equity. Why ?

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