Tax Effect on the Cost of Capital
With respect to taxes, it is important to keep in mind that interest payments on debt can be deducted as expenses and thus reduce overall taxes. However, a company cannot report dividends as an expense, so dividends have no effect on the taxes of a company. This is important for a company to keep in mind when determining and making changes to its capital structure.

Bankruptcy Effect on the Cost of Capital
Bankruptcy costs can also significantly affect a company's cost of capital. When a company invests in debt, the company is required to service the debt by making required interest payments. Interest payments alter a company's earnings as well as cash flow. For each company there is an optimal capital structure, including a percentage of debt and equity, a balance between the tax benefits of the debt and the equity. As a company continues to increase its debt over the amount stated by the optimal capital structure, the cost to finance the debt becomes higher as the debt is now riskier to the lender. The risk of bankruptcy increases with the increased debt load. Since the cost of debt becomes higher, the WACC is thus affected. With the addition of debt, the WACC will at first fall as the benefits are realized, but once the optimal capital structure is reached and then surpassed, the increased debt load will then cause the WACC to increase significantly.
 



The MM Capital Structure vs. The Tradeoff Theory of Leverage

Related Articles
  1. Investing

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  2. Investing

    Evaluating a Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  3. Taxes

    When To Declare Bankruptcy

    When is bankruptcy the best or only route– and when is it better to look at alternative solutions? And should you always hire a lawyer?
  4. Taxes

    Changing The Face Of Bankruptcy

    A 2005 law attempts to unmask fraudulent debtors and still save those who are struggling. Will it affect you?
  5. Taxes

    How To Survive A Bankruptcy Filing

    Learn how to make filing for bankruptcy less painful so you can successfully rebuild your financial life.
  6. Small Business

    Taking Advantage Of Corporate Decline

    A bankrupt company can provide great opportunities for savvy investors.
  7. Insights

    The National Debt Explained

    We know it's growing, but we don't know exactly how. An in-depth look why the U.S. Government's debt continues to balloon and what it all means for you.
  8. Financial Advisor

    Should You File For Bankruptcy?

    Find out how to determine whether this option will help or hurt your financial situation.
Frequently Asked Questions
  1. Who are Whole Foods' (WFM) main competitors?

    Learn more about Whole Foods Markets, who insists its products are sustainable. Thanks to the competition, however, its marketing ...
  2. What are the Differences Between Ex Works (EXW) and Free On Board (FOB)?

    Learn about Ex Works and Free on Board, the main difference between these Incoterms, and the responsibilities of buyers and ...
  3. What are Common Examples of Monopolistic Markets?

    Discover what causes real instances of market monopoly, how it persists and where monopoly privilege is most common in the ...
  4. What is the gold standard?

    The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold, but ...
Trading Center