Taxes the WACC and Proposition II

The conclusion that the best capital structure is 100 percent debt also can be reached by examining the weighted average cost of capital. From our previous chapter, we know that, once we consider the effect of taxes, the WACC is:

Ross et al.: Fundamentals I VI. Cost of Capital and I 17. Financial Leverage and I I © The McGraw-Hill of Corporate Finance, Sixth Long-Term Financial Capital Structure Policy Companies, 2002

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582 PART SIX Cost of Capital and Long-Term Financial Policy

To calculate this WACC, we need to know the cost of equity. M&M Proposition II with corporate taxes states that the cost of equity is:

To illustrate, recall that we saw a moment ago that Firm L is worth $7,300 total. Because the debt is worth $1,000, the equity must be worth $7,300 - 1,000 = $6,300. For Firm L, the cost of equity is thus:

Re = .10 + (.10 - .08) X ($1,00016,300) X (1 - .30) = 10.22%

The weighted average cost of capital is:

WACC = ($6,30017,300) X 10.22% + (1,00017,300) X 8% X (1 - .30) = 9.6%

Without debt, the WACC is over 10 percent, and, with debt, it is 9.6 percent. Therefore, the firm is better off with debt.

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