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As we know, considering the economical issues, a big step has been taken by the Government of India in the form of corporate tax reductions. Assuming other factors will remain constant; this step will lead to an increase the production, demand, and employment as well. But, from the viewpoint of a company whether tax benefits only impact its tax burdens?

  • With respect to the subject, the Capital structure of the company comprises financing through debt or equity or combinations of both. The weighted average cost of capital (WACC) depends on the capital structure of the company. WACC is the overall cost of funds obtained by the company and it is considered while calculating returns to be earned by the company on investments made, as ROI must be higher than WACC. A capital structure having lower WACC with manageable risk is considered as optimum. But, companies having a good capital structure will be affected by corporate tax rate reductions, as tax rate have major consideration while calculating WACC of the company.

WACC = (Kd x Wd)(1 - T) + (Ke x We)

W = Weight in capital structure
d = Debt, e = Equity
K = Cost of respective fund
T = Tax rate

Cost of Debt:

  • If we interpret the above formulation, (Kd x Wd) is having multiplier of (1 - T) meaning thereby cost of debt is benefited by the tax shield on interest incurred on debt. Such tax shield suggests saving in tax payable by the company due to interest incurred and this is one of the major reasons of debt being a cheaper source of finance. But, the decrease in tax rate will reduce the benefit of tax shield; increases the cost of debt and ultimately results in higher WACC.
  • Considering the tax impact in above formulation by following two different situations:
Impact of Corporate Tax reduction on Cost of Capital of the Company
   

Components

Original Tax Rate

Reduced Tax Rate

Kd (before tax shield)

11%

11%

Ke

16%

16%

Wd

40%

40%

We

60%

60%

T

30%

22%

WACC (above formula)

12.68%

13.03%

  • Even though weights and costs are same in both the situations, but reduction in tax rate i.e. (T) leads to increase the multiplier (1 - T) to the cost of debt. So, company having capital structure comprises high debts will get affected due to tax reductions and accordingly alteration of its capital structure will be required because no company will ready to bear the high risk of debt with high cost.
 

Cost of Equity:

  • Cost of equity is depending upon the dividend distributed by the company as well as growth of the company and such growth is based upon profits retained by the company. Tax reductions will increase the profit after tax (PAT) and accordingly profit available to equity shareholders, but will it actually increases the cost of equity or not? That is subjective in nature because cost of equity is complex as it indicates the expectations of shareholders and also based upon market price. Now, increase in PAT due to decrease in tax will actually affect the expectations of shareholders and to which extent? It can't be measured by figures. So, before evaluating this kind of impact, we should also consider some non-financial factors as well.
 

Conclusion:

  • We can conclude from above that reduction in tax rate will lead to change the cost of capital of companies but, degree of such change is subjective due to weights of respective funds in capital structure and impact on cost of equity which is substantially depending on behaviour of shareholders and their expectations from different companies.

The author can also be reached at yash.panjwani27@gmail.com

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Category Income Tax, Other Articles by - Yash Panjwani 



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