The effect of U.S tax cut and increasing risk free rate in Turkey on weighted average cost of capital (WACC)
The article prepared by Besfin Financial Services & Advisory is about effect on weighted average cost of capital of companies in USA and Turkey with the recent developments. ABD ve Türkiye’de yaşanan gelişmelerin, şirketlerin ağırlıklı ortalama sermaye maliyetleri üzerine etkisi araştırılmıştır. To summarize :
Despite the positive impact of companies’ cash flows, the tax cut in USA increase companies’ cost of debt, thus WACC. As a result, some companies in S&P 500 index are expected to change their capital structure to reach optimal capital structure. On the other hand, increase in risk free rate affects both cost of equity and cost of debt as well as WACC of Turkish companies increase. Turkish companies might resort to alternative funding ways such as mezzanine funds, mergers and acquisitions, or capital raising through public offerings in the coming periods.
This article is prepared for company owners, people who wants to make new investments and start a new business, with the purpose of informing about WACC. Besfin Financial Services & Advisory supports companies on corporate finance, project financing as well as mergers and acquisitions, and help them to raise most suitable and cost efficient funding with its experienced directors and dynamic staff.
Tax Effect on Weighted Average Cost of Capital
The weighted average cost of capital is a measure used by companies to track whether they have the right capital structure as well as to determine how much return on invested capital (ROIC) ratio should be. The ROIC of a healthy company is expected to be greater than WACC. Thus, companies want to keep WACC rate at minimum. The point where WACC is minimum is referred to as optimal capital structure. The two components that affect WACC are cost of equity, and cost of debt. The cost of equity is often higher than cost of debt. Additionally, the amount paid fort he interest of debts is tax deductible. which is called tax shield. The tax shield effect is related to the corporate tax rate of a country.Simply, lower the tax rate, higher the cost of debt.
According to J.P. Morgan’s research, it is estimated that companies in the S&P 500 index have the lowest WACC rating in the BBB rating range. Number of companies with BBB rating has increased in the recent years.
S&P 500 Companies Credit Ratings 1993 (graphic 1)
S&P 500 Companies Credit Ratings 2017 (graphic 2)
Corporate Tax Cut and WACC in USA
As explained earlier, the decrease in tax rate cause WACC to increase. The average WACC of companies in S&P 500 index is 7,17% with 35% corporate tax, and 7,32% with 21% corporate tax with the assumption of other inputs remain stable.
The tax cut would also change optimal capital structure of companies. Companies could choose to use less debt since cost of debt would increase. With the new tax rate, WACC of companies with A credit rating would be lower than companies with BBB rating.
WACC and Risk Free Rate Increase in Turkey
On the other hand, corporate tax rate is increased from 20% to 22% in Turkey. It is expected that the increase in corporate tax rate will have opposite effect to the U.S.A tax reduction. Unfortunately, this effect is not felt due to the increase in risk free interest rates
As can be seen from the graph there is an increasing trend in risk free rates. At the beginning of 2015, the risk free rate was 7,92% and it was 11,44% at the beginning of 2018. The increase in risk free rate has considerably increased cost of debt. This increase also increased cost of equity, thus WACC.