Doubts

Exercise Set - Capital Structure

Exercise Set - Capital Structure

by Sofia Lampreia Alves Garcia -
Number of replies: 1

Hi Professor, 

I’m working on Exercise 2 of the Capital Structure set and I have a question.

In the solution, the cost of equity with D/E = 3 is calculated as: Re=Ra+ED​(Ra−Rd)=19%

But I used the formula with taxes, like in the previous question: Re=Ra+ED​(Ra−Rd)(1−t)=16.375%

Should we include the tax shield here, or ignore taxes for this one?

Thank you,

Sofia

In reply to Sofia Lampreia Alves Garcia

Re: Exercise Set - Capital Structure

by Julio Crego -

Hi Sofia, 

I am not completely sure where the second formula comes from, but we use it without taxes. The reason is that when we pay equityholders, we always pay taxes, so their expected return and the cost for the firm are the same. This is not true for debt holders. For every euro that debtholders get, we pay 0.75 because we deduct the other 0.25.