ACCA Financial Management (F9) Certification Practice Exam

What is the main advantage of leveraging tax relief on interest payments, as discussed under WACC with tax?

1. It increases the overall cost of capital

2. It decreases WACC

3. It allows for greater equity issuance

4. It has no significant impact on financing costs

The correct answer is: It decreases WACC

The main advantage of leveraging tax relief on interest payments is that it decreases the weighted average cost of capital (WACC). When a company incurs debt, the interest payments on that debt can be deducted from its taxable income, providing a tax shield. This effectively reduces the company's overall tax liability and, as a result, the after-tax cost of debt is lower than the nominal cost of debt. By lowering the after-tax cost of debt in the WACC calculation, the overall cost of capital decreases. This makes it cheaper for the company to finance its operations and investments through a mix of debt and equity. A lower WACC can make a company more attractive to investors, as it implies that the company can achieve a higher return on investments relative to its capital costs. Tax benefits linked to debt encourage firms to use leverage strategically to optimize their capital structure, enhancing value and potentially increasing the returns for equity shareholders.