CS Executive · Corporate Accounting and Financial Management · Cost of Capital
Which cost of debt should be used when computing WACC for a company that pays tax?
The post-tax cost of debt should be used. Interest is a tax-deductible expense, so the firm's effective cost is the interest rate multiplied by one minus the tax rate. Using the pre-tax rate would overstate the weighted average cost of capital.
- APre-tax cost of debt, since interest is a contractual outflow
- BPost-tax cost of debt, since interest is tax deductibleCorrect
- CCoupon rate on preference shares
- DCost of retained earnings
Explanation
Interest on debt is deductible, so the effective cost to the firm is Kd(1 - t). WACC uses this post-tax figure. Using the pre-tax rate would overstate WACC.
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