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VIPSolutions · Accepted Answer

## Objective

**Determine the appropriate tax rate to use in the calculation of the debt component of LilyMac’s WACC (Weighted Average Cost of Capital).**

---

## Given Data

- **EBIT:** \$96,000 per year
- **Bonds Outstanding:** 400 bonds, 10-year, 4% annual coupon
- **Tax rate considered:** 34% (but answer is flagged incorrect)

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## Step 1: Understanding WACC Tax Rate for Debt

- In WACC calculation, the tax rate applied to the debt component should be the **firm's marginal tax rate**.
- The marginal tax rate is the tax rate paid on the firm's last dollar of taxable income.
- The question does **not** provide a marginal tax rate, but it is possible that we need to use the **statutory corporate tax rate** unless otherwise specified.

---

## Step 2: Identifying the Correct Tax Rate

- In the US, the **federal corporate tax rate** has been **21% since 2018**.
- If no state tax or other adjustments are mentioned, **21% is the default assumption** for questions after 2018.
- The **34% rate** was common *before* the 2018 tax reform.

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## Step 3: Final Check

- There is no mention of additional state or local taxes.
- No indication that the firm is in a loss position (which would affect effective tax rate).
- **Therefore:** The appropriate tax rate for the debt component of WACC is **21%**.

---

## **Final Answer**

**The appropriate tax rate to use in the calculation of the debt component of LilyMac’s WACC is:**

$$
\boxed{21\%}
$$

**Summary:** The tax rate used should be the current US federal corporate tax rate of 21%, unless otherwise specified by the problem.

VIPSolutions · Answer

# Explanation of Each Step

## Step 1: Understanding WACC Tax Rate for Debt
In calculating the Weighted Average Cost of Capital (WACC), the tax rate applied to the debt component is usually the firm's marginal tax rate. This rate reflects the tax burden on the last dollar of income and is essential for determining the after-tax cost of debt.

## Step 2: Identifying the Correct Tax Rate
The federal corporate tax rate in the United States has been set at 21% since the tax reform of 2018. Unless additional information about state taxes or specific circumstances affecting the firm's tax situation is provided, this rate is typically used for WACC calculations post-2018.

## Step 3: Final Check
Given there are no indications of other applicable taxes or losses impacting the effective tax rate, the standard federal rate applies. Thus, the appropriate tax rate for the debt component of LilyMac's WACC is confirmed to be 21%.

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