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Hello Sir!
“When discounting the tax shield arising from debt financing, it’s common practice to use either the risk-free rate or the pre-tax cost of debt. However, when calculating the Weighted Average Cost of Capital (WACC), we typically use the *post-tax* cost of debt. Why do we discount the tax shield using pre-tax rates, rather than post-tax rates, which would seem more consistent with the WACC calculation?”
Thank you!
We are discounting the tax shield at the rate applicable to the level of risk.
Since the tax saving is based on the debt interest, if we assume the debt to be risk free then so will be the tax saving on the interest and therefore we use the risk free rate. (To discount at the after-tax risk free rate would be accounting for the tax saving twice).
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