Summit Builders has a market debt-equity ratio of 0.65 and a corporate tax rate of 40 %, and it pays 7 % interest on its debt. The interest tax shield from its debt lowers Summit's WACC by what amount?
Business · High School · Tue Nov 03 2020
Answered on
The interest tax shield effect on a company's Weighted Average Cost of Capital (WACC) can be calculated using the formula:
Interest Tax Shield = Debt * Tax Rate
Given:
Market Debt-Equity Ratio = 0.65
Corporate Tax Rate = 40%
Interest Rate on Debt = 7%
Let's assume Summit Builders' total debt or the value of debt can be derived from the debt-equity ratio. If the market debt-equity ratio is 0.65, the debt portion would be 0.65/(1 + 0.65) = 0.65/1.65 = 0.3939 (approximately 39.39% debt).
Interest Tax Shield = Debt * Tax Rate
Interest Tax Shield = 0.3939 * 0.40
Interest Tax Shield = 0.15756
This value represents the amount by which Summit's WACC is reduced due to the interest tax shield effect. In this case, it lowers Summit Builders' WACC by approximately 15.756%.