In calculating the weighted average cost of capital (WACC), why is the after-tax cost of debt multiplied by (1 - t)?

In calculating the weighted average cost of capital (WACC), why is the after-tax cost of debt multiplied by (1 - t)?

• A. To reflect the tax shield on debt
• B. Because debt is always the cheaper source of financing
• C. To reflect equity risk in the discount rate
• D. To align with inflation adjustments

Answer: (A)

The main idea here is the tax shield that debt provides. Interest paid on debt is tax-deductible, so the company saves taxes equal to the tax rate on the interest expense. That tax saving reduces the actual cost of borrowing to the lender’s rate times (1 minus the tax rate). In WACC, you reflect this by using the after-tax cost of debt, Rd*(1 − t). For example, if the debt cost is 6% and the corporate tax rate is 30%, the tax shield reduces the net cost to the company to 6% × (1 − 0.30) = 4.2%. This lower after-tax cost is what influences the WACC, since debt financing becomes cheaper after considering taxes. The other parts of WACC treat debt and equity differently: only debt gets the tax shield because interest is deductible, whereas equity does not enjoy a tax deduction on dividends or returns.

The main idea here is the tax shield that debt provides. Interest paid on debt is tax-deductible, so the company saves taxes equal to the tax rate on the interest expense. That tax saving reduces the actual cost of borrowing to the lender’s rate times (1 minus the tax rate). In WACC, you reflect this by using the after-tax cost of debt, Rd*(1 − t).

For example, if the debt cost is 6% and the corporate tax rate is 30%, the tax shield reduces the net cost to the company to 6% × (1 − 0.30) = 4.2%. This lower after-tax cost is what influences the WACC, since debt financing becomes cheaper after considering taxes. The other parts of WACC treat debt and equity differently: only debt gets the tax shield because interest is deductible, whereas equity does not enjoy a tax deduction on dividends or returns.