WACC: Why Tax-Adjust Debt but Not Equity?

Let’s talk about something really important in the world of business finance: the Weighted Average Cost of Capital, or WACC for short. Think of WACC as the overall price a company pays to use money to fund its operations and growth. Companies get their money from different places, primarily debt and equity. Debt is essentially borrowing money, like taking out a loan, and equity is like selling pieces of ownership in the company, often through stock.

Now, when we calculate WACC, we need to figure out the cost of each of these sources of funding. Here’s where the interesting tax difference comes in, specifically between debt and equity. When a company borrows money, it usually pays interest on that loan. This interest expense is considered a cost of doing business, just like paying for raw materials or employee salaries. And because it’s a business expense, guess what? It’s tax-deductible.

Imagine you own a small bakery. If you take out a loan to buy a new oven, the interest you pay on that loan can reduce your bakery’s taxable income. This is because governments generally want to encourage businesses to invest and grow, and allowing interest deductibility is one way to do that. So, by deducting interest, the government is essentially sharing some of the cost of borrowing with the company in the form of lower taxes. We call this the ‘tax shield’ of debt. It’s like having an umbrella that shelters you from some of the tax rain.

To illustrate, let’s say your company makes a profit of $100,000 before paying interest and taxes. If you have $20,000 in interest expense, your taxable income becomes $80,000. Assuming a corporate tax rate of 25 percent, your tax bill would be 25 percent of $80,000, which is $20,000. If you hadn’t had any debt and therefore no interest expense, your tax bill would have been 25 percent of the original $100,000 profit, which is $25,000. See how the interest expense saved you $5,000 in taxes? This $5,000 tax saving is the tax shield.

Because of this tax shield, the actual cost of debt to the company is lower than the stated interest rate. When calculating WACC, we need to reflect this lower cost. That’s why we adjust the cost of debt for taxes. The formula is typically something like: Cost of Debt multiplied by (1 minus the tax rate). This gives us the after-tax cost of debt, the real cost to the company after considering the tax savings.

Now, let’s switch gears to equity. When companies raise money by selling stock, they are essentially selling ownership in the company. In return for their investment, shareholders expect a return, which can come in the form of dividends or an increase in the stock price. However, unlike interest on debt, payments to equity holders, such as dividends, are not tax-deductible for the company.

Think back to our bakery. If instead of taking out a loan, you sold shares of your bakery to raise money for the oven, any dividends you pay to these shareholders come out of the bakery’s profits after taxes have already been paid. Dividends are considered a distribution of profits to owners, not a business expense that reduces taxable income. Similarly, retained earnings, which are profits reinvested back into the business, are also from after-tax profits.

So, there is no tax shield associated with equity financing in the same way there is for debt financing. The cost of equity, which is the return required by investors for holding the company’s stock, is already considered an after-tax cost from the company’s perspective. It’s the return investors demand after corporate taxes have been paid on the company’s profits. Therefore, we don’t need to adjust the cost of equity for taxes when calculating WACC. We use the cost of equity as it is, reflecting the return shareholders expect.

In essence, the tax deductibility of interest creates a significant difference between debt and equity financing. Debt becomes cheaper on an after-tax basis due to the tax shield, while equity’s cost is not reduced by any similar tax benefit at the company level. This fundamental difference is why we adjust the cost of debt for taxes in the WACC calculation, to reflect its true after-tax cost, while the cost of equity remains unadjusted. It’s all about accurately reflecting the real cost of each type of financing for the company, taking into account the tax rules of the game.