Firm A‘s capital structure contains 20% debt and 80% equity. Firm B’s capital structure contains 50% debt and 50% equity. Both firms pay 7% annual interest on their debt. The stock of Firm A has a beta of 1.0, and the stock of Firm B has a beta of 1.375. The risk-free rate of interest equals 4%, and the expected return on the market portfolio equals 12%.
a. Calculate the WACC for each firm, assuming there are no taxes.
b. Recalculate the WACC for each firm, assuming that they face a tax rate of 34%.
c. Explain how taking taxes into account in part (b) changes your answer from part (a).