Which of the following must be adjusted for taxes when calculating the weighted average cost of capital? (Select the best choice below)
A. Preferred stock
B. Debt
C. Retained earnings
D. Common stock
The correct answer and explanation is:
The correct answer is B. Debt.
When calculating the Weighted Average Cost of Capital (WACC), taxes must be adjusted for debt because the interest paid on debt is tax-deductible. This means that companies can lower their taxable income by the amount of interest they pay on debt, which reduces their overall tax burden. The tax shield provided by the deductibility of interest payments makes debt financing cheaper than equity financing.
The formula for WACC is: WACC=(EV×Re)+(DV×Rd×(1−Tc))WACC = \left( \frac{E}{V} \times Re \right) + \left( \frac{D}{V} \times Rd \times (1 – Tc) \right)
Where:
- E is the market value of equity
- D is the market value of debt
- V is the total market value of the company (E + D)
- Re is the cost of equity
- Rd is the cost of debt
- Tc is the corporate tax rate
In this equation, the cost of debt, Rd, is multiplied by (1−Tc)(1 – Tc), where TcTc represents the corporate tax rate. This adjustment reflects the tax benefit of debt financing, which lowers the effective cost of debt.
The other options (A. Preferred stock, C. Retained earnings, D. Common stock) do not require tax adjustments in the WACC calculation. Preferred stock and equity financing are not tax-deductible, so they do not receive a tax shield like debt does. Retained earnings, which represent profits that are reinvested in the business rather than paid out as dividends, are considered part of common equity and are treated the same way as common stock for WACC purposes. Therefore, taxes are not adjusted for preferred stock, retained earnings, or common stock when calculating WACC.