WACC: Why the net cost of debt is used

[maz1987]

I am wondering why the tax deduction on loan capital provides a tax shield to ensure the cost of loan capital is less than the cost of equity capital, and why its inclusion results in a justifiable WACC.

Using the Growmore plc example of Chapter 15:

• The loan stock pays 10% interest pa,
• The equity investors require 12% yield on their investment
• $100m is provided by the creditors and $100m by the shareholders
• A 30% corporate tax rate exists (an added feature to the Growmore plc example)

Then the WACC would be [ 0.1*(1 - 0.3)*100 + 0.12*100 ] / 200

=9.5%

So if they manage to earn the 9.5% on the $200m assets, then that would result in $19m.

This is where I start to lose track. Of that $19m earnt on the assets, $10m is paid to the creditors to satisfy their 10% yield, the remaining $9m is taxed at 30% to leave $6m, meaning the shareholders only get paid $6m of the $12m that they require.

What am I assuming incorrectly here?

Thanks

 

[didster]

As far as the WACC goes

The idea is that interest payments on the loan can be considered an expense and offset against profit, thereby lowering tax liability.

Also the WACC is a net of tax figure.

So in the example
Income before interest is 27.142
Interest on loan is 10
Profit after interest payments is 17.142
tax = .3* 17.142 = 5.142
Remaining profit attributable to equity holders is 12.

If an alternative company was 100% equity with same income

income =27.142
tax = .3* 27.142 = 8.142
Net profit = 19 or 9.5%