The Weighted Average Cost of Capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation. A firm’s WACC increases as the beta and rate of return on equity increase because an increase in WACC denotes a decrease in valuation and an increase in risk.
In order to account for the tax benefits of debt, the WACC can be calculated to account for tax benefits in a Classical Tax System and an Imputation Tax system. While both classical and imputation systems work with a set tax rate set by a governing body, the imputation tax system accounts for the implementation of franking credits while the classical tax system accounts for just the flat tax rate. This page will explore the Imputation Tax System Weighted Average Cost of Capital.
The Weighted Average Cost of Capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The Imputation Tax System WACC calculates the WACC by including the tax rate and franking credits that are issued as part of an imputation tax system.
The market value of equity is the value of the firm that is financed by equity. Equity is the value of assets after subtracting the amount of debt held by the firm. The more a company is financed by equity over debt, the less tax benefits from debt it will receive.
The market value of debt is the value of the firm that is financed by debt. Debt is the financing acquired by a firm through lenders such as banks and other financial institutions.
The market value of a firm is the total value of debt and equity for a firm.
The expected or required rate of return on equity held by a firm.
The expected or required rate of return on debt held by a firm.
The Company Tax Rate is the rate of tax the company pays depending on which government or country it operates within.
A franking credit is a tax credit paid by corporations to their shareholders along with their dividend payments. Countries such as Australia allow franking credits as a way to reduce or eliminate double taxation. Depending on their tax bracket, investors who receive a franking credit may get a reduction in their income taxes or a tax refund.
The value for weighted average cost of capital after calculating the WACC using the variables provided above. This value can be used to calculate Free Cashflow to Firm or other formulas that use the Weighted Average Cost of Capital.
Using the formula and variables provided, the Weighted Average Cost of Capital can be calculated for a firm that pays taxes in an imputation tax system. Assume you want to know the weighted average cost of capital for a firm you are considering investing in. The firm has a value of $50,000,000 that is financed with 30% debt. The return on equity for the firm is 12%, return on debt is 14%, the tax rate is 30% and the franking credit is issued at 95%. Using the following formula, the WACC for the company can be calculated as follows:
WACC = (E/V)*Re + ((1-TC) / (1-TC*(1-FC))) + (D/V)*Rd*(1-TC)
WACC = (35,000,000/50,000,000)*0.12 + ((1-0.3) / (1-0.3*(1-0.95))) + (15,000,000/50,000,000)*0.14*(1-0.30)
WACC = 8.91%
The value for the WACC in this example is 8.91%. As an investor you can take this WACC value and plug it into other formulas that require a WACC value, such as FCFF Single Stage, and determine the value of a firm you are considering investing in.
The Weighted Average Cost of Capital formula for an Imputation Tax System is applied to calculate the WACC of a firm that holds debt. Debt to a firm comes with risks such as potential bankruptcy should the firm be unable to pay its debts, but debt also comes with some tax benefits to a firm as debt financing is often cheaper to gain and maintain than equity financing. Imputation Tax Systems also issue a franking credit that can be used by investors to gain a tax credit for all taxes already paid by the company that has issued the dividends. This means that if the issuing company pays a tax rate of 30% and there is a 100% franking credit, an individual who pays income tax of 45% on income from dividends is reimbursed the full 30% of all earnings from that company’s dividends. For companies, debt financing allows the owners of the company to remain in control of the decisions and trajectory of their firm as equity financing often means selling off shares in the firm to individual investors.
The Imputation Tax System WACC is useful for determining the cost of debt to a levered firm under evaluation by investors. It takes into consideration the value of equity and debt financing, or the debt to equity ratio, of a firm. This information is useful to investors when evaluating a firm for investment in either shares, bonds or other financial assets issued by the firm. Imputation tax systems allow companies to issue a franking credit that allows investors to reclaim part of the tax paid from dividend earnings from that company up to the value of the franking credit on those dividends.
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