Corporate America’s cost of servicing its debt went up as Trump’s massive corporate tax rate cut—from 35% down to 21% at the end of 2017—reduced the size of the tax shield associated with debt financing. What’s more, this had a potentially negative impact on its weighted average cost of capital (WACC) overall. Slashing the tax rate might have complicated further capital investment by the business community—and in turn, growth in wages and GDP—rather than facilitated more of it as per the stated intentions of the Tax Cuts and Jobs Act.
WACC is the weighted average of a corporation’s cost of equity plus its after-tax cost of debt. Put another way,
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. ~Wikipedia
In corporate finance, it can be utilized as a hurdle rate, a measure by which a company may determine whether or not a capital investment project has a chance of being sufficiently profitable (or otherwise beneficial) and should therefore be undertaken. One example of this is the discounting at the WACC of expected cash flows attending a large purchase of advanced equipment, so as to gauge if it could be a revenue-generating enterprise that returns value to invested stakeholders.
Slashing the corporate tax rate back in 2017 via the Tax Cuts and Jobs Act made it more costly for Corporate America to service its outstanding debt due to the cut’s impact on the tax shield, which mitigates a corporation’s interest expense. This thereby created the potential for the WACC to increase for any company whose capital structure consists of debt as well as equity. That is, their weighted average cost of capital—that rate they are expected to pay on average to their providers of capital such as shareholders and creditors, in order to finance their assets—also possibly became more expensive as a direct result.
Hence, while the tax cut was supposedly implemented to spur investment in capital projects and set off a chain reaction that would eventually lead to higher wages and GDP growth, it may have actually made it more difficult for businesses to do just that.
WACC: The basics, illustrated
Key inputs in calculating the WACC include the corporation’s capital structure, or how much debt and equity it is comprised of; its cost of equity, also known as the required rate of return (we use CAPM to calculate this for publicly-traded firms, where cost of equity could be thought of as the required rate of return on equity in the stock markets); and its cost of debt, or the interest rate it pays. Another critical input, our star of the show, is the tax rate that the corporation is subject to (often a mix of state and federal tax rates), referred to as the effective tax rate.
The tax shield is a thing because we allow Corporate America to deduct its interest payments on debt from the taxes it owes the government. This reality reduces a company’s tax bill. Instead of thinking about it that way, though, we show this formulaically in Finance as a reduction in the interest rate the business pays to service the debt it has taken on.
Here is the full formula:
To briefly explain the above (from left to right): the WACC rate is equal to the percentage of the company’s entire capital structure that is debt, multiplied by the blended interest rate on that debt, multiplied by the tax savings (1 minus the effective tax rate); plus the percentage of the capital structure that is equity, multiplied by the expected return on its stock.
And here is that tax shield portion, isolated:
From the above, rD is the blended interest rate paid on all outstanding debt the company has assumed, and rT is the effective corporate tax rate. Therefore, 1-rT represents the amount that doesn’t go to Uncle Sam. This whole tax shield section of the WACC formula is, practically speaking, tax savings, sure, but viewed from another angle, the debt rate is being modified by these tax savings as per the formula. This is what we’re honing in on, and it makes the “after tax cost of debt” more appropriate terminology for our discussion.
If you’re paying attention, you can clearly see that there’s a trade-off between the tax charge and the after-tax debt rate. Keeping all else equal, if we assume a lower tax rate, the cost of debt (and the WACC more generally) will go up, while a higher tax rate will cause the cost of debt (and the WACC) to decrease.
We can easily verify this by working through a quick and dirty example and changing nothing but the tax rate.
Once again, our formula:
Take Target (TGT), with a reported $11.518 billion in debt and $11.836 billion in equity (as of fiscal Q2–2020), with known associated debt (10.43%) and expected equity return (9.83%) rates from other calculations performed on the side. Back in the days of the old 35% federal tax rate, TGT’s effective tax rate was 32.7%. Thus, their WACC would have come out to be:
At the present 21% federal tax rate, their effective tax rate is 20.3%, and their WACC now turns out to be:
The after-tax cost of debt changed from 7.02% to 8.32%, an increase of 130 basis points. To put this into context, it makes for a difference of nearly $15 million in interest expense that TGT can no longer deduct. Additionally, it’s enough to give management pause when the question of assuming more debt comes up.
Meanwhile, the WACC rose from 8.45% to 9.08%, an increase of over 60 basis points. Future capital projects would currently have a higher hurdle rate to clear to be taken seriously. Again, this assumes that all else stays the same; no changes in any other conditions.
The tax cut: Other implications
You may have realized that a higher after tax cost of debt would disproportionately impact companies that were already holding large amounts of debt, since the ongoing cost of that debt would have gone up accordingly. Whereas a tax cut was presumably supposed to fuel business investment, it might have actually forced the hands of specific companies with high debt loads to utilize their tax cut savings to retire at least some of their debt early, in order to combat a sudden increase in expenses.
True, the decision to do just that could have made certain companies healthier by improving their balance sheets (for the time being), with the tax cut acting as a lifeline, if you will. However, in some cases, it may have only served to delay the inevitable demise of others (think JC Penney). At any rate, the conclusion is not further capital investment.
Equally important and worthy of reiteration is the point that an increase in the after-tax cost of debt signifies that some companies might have a harder time justifying capital projects and expansion financed with debt, since that debt is now costlier and the WACC hurdle possibly harder to clear. This is especially true for longer-term projects where multi-year debt facilities would otherwise be sought. In turn, this could put a damper on a company’s—as well as the economy’s—growth prospects, and perhaps even negatively impact GDP over time. That certainly seems counterintuitive, considering the tax cut benefits that were promised back in 2017, namely increased business investment.
In fact, how ironic it would be to have less business investment, in part because the after-tax cost of debt, and the WACC overall, went up. If we choose to believe in the ostensible outcomes of the corporate tax cut, we may view what has been outlined here as a set of unintended consequences, and the subsequent behavior of Corporate America as a collection of reactions to unintended incentives.
This may lend partial insight into why Trump remains so simplistically interested in the Federal Reserve cutting interest rates again. Ceteris paribus, lower interest rates could mean lower pre-tax debt rates for corporations—if the yield curve responds in a certain way—which would counteract higher post-tax debt rates given the giant tax cut. From the vantage point of its dual mandate, though, the Fed looks to have been doing its job, so the White House may have to perform some much needed introspection and devise an in-house solution to any related economic predicament that’s brewing.