The concept of a tax shield is integral to the understanding of corporate finance, particularly when it comes to evaluating a company's cost of capital. Essentially, a tax shield refers to the reduction in income taxes that a firm can achieve through the use of various deductions, such as interest expenses. This reduction in taxable income ultimately leads to a lower tax payment, which can have a significant impact on the firm's overall cost of capital, known as the weighted Average Cost of capital (WACC).
WACC is a critical financial metric used to assess the average rate of return a company is expected to pay its security holders to finance its assets. It is calculated by weighting the cost of each capital component—equity, debt, preferred stock—by its respective proportion in the overall capital structure. The formula for WACC is as follows:
$$ WACC = \frac{E}{V} \times Re + \frac{D}{V} \times Rd \times (1 - Tc) $$
Where:
- \( E \) = Market value of the equity
- \( V \) = Total market value of equity and debt
- \( Re \) = Cost of equity
- \( D \) = Market value of the debt
- \( Rd \) = Cost of debt
- \( Tc \) = corporate tax rate
From different perspectives, the tax shield can be seen as a strategic tool for financial management. Here are some insights:
1. From a Corporate Finance Perspective:
- The tax shield is a way to leverage debt financing to reduce taxable income, thereby lowering the WACC. This can make investment projects more attractive and increase the value of the firm.
- For example, if a company has a high cost of equity, it might opt to increase its debt load to take advantage of the tax shield and reduce its WACC.
2. From an Investor's Perspective:
- Investors often look at WACC as a benchmark for investment returns. A lower WACC due to tax shields might signal a potentially undervalued investment opportunity.
- However, investors also need to be wary of companies that might over-leverage to achieve a tax shield, as this can lead to increased financial risk.
3. From a Tax Planning Perspective:
- Tax shields are a crucial aspect of tax planning for firms. They allow companies to strategically plan their financing in order to minimize tax liabilities.
- For instance, a company might choose to finance a new project with debt rather than equity because the interest payments are tax-deductible.
4. From a risk Management perspective:
- While tax shields can reduce WACC, they also introduce debt-related risks. Companies must balance the benefits of a tax shield with the risks associated with increased debt levels.
- A practical example is a company that carefully manages its debt-to-equity ratio to maintain a healthy balance between enjoying tax benefits and avoiding excessive leverage.
The interplay between tax shields and WACC is a nuanced area that requires careful consideration from multiple angles. By understanding how tax shields can affect WACC, companies can make more informed decisions about their capital structure and financing strategies, ultimately leading to better financial health and value creation for shareholders.
Introduction to Tax Shield and WACC - Tax Shield: Understanding the Tax Shield s Impact on WACC
Understanding the concept of a tax shield is crucial for both individuals and businesses as it directly affects the Weighted average Cost of capital (WACC). A tax shield refers to the reduction in income taxes that results from taking an allowable deduction from taxable income. For companies, this often comes in the form of depreciation, amortization, or interest expenses. These deductions lower taxable income, thereby reducing the amount of tax owed. The savings generated can have a significant impact on a company's WACC, which is the average rate a company expects to pay to finance its assets, weighted by the proportion of equity and debt in its capital structure.
From a financial perspective, the tax shield is a strategic tool that can be leveraged to enhance a company's value. Here's how it works in detail:
1. interest Expense deduction: When a company takes on debt, the interest paid on that debt is tax-deductible. This means that for every dollar of interest paid, the company's taxable income is reduced by the same amount, leading to tax savings. For example, if a company has an interest expense of $1 million and a corporate tax rate of 30%, the tax shield would be $300,000 ($1 million * 30%).
2. Depreciation and Amortization: These non-cash expenses also serve as tax shields. While they reduce the company's reported earnings, they do not involve an actual cash outflow. As such, they provide a tax benefit without affecting the company's cash position. For instance, if a company reports a depreciation expense of $500,000 with a tax rate of 30%, it saves $150,000 in taxes.
3. Deferred Taxes: Companies can defer taxes through various accounting methods, such as accelerating depreciation or deferring income recognition. This deferral creates a temporary tax shield, which can be advantageous for cash flow management.
4. Loss Carryforward: Businesses that incur losses can carry forward these losses to offset future taxable income, creating a tax shield in profitable years. This can be particularly beneficial for startups and companies in cyclical industries.
5. tax Credits and incentives: Governments often offer tax credits for specific activities, such as research and development or investments in renewable energy. These credits directly reduce the tax liability, acting as a tax shield.
The impact of a tax shield on WACC is significant because it effectively lowers the cost of debt. Since interest is tax-deductible, the after-tax cost of debt is less than the nominal interest rate. This reduction in the cost of debt lowers the WACC, making it cheaper for the company to finance its operations and investments. Consequently, a lower WACC can increase the company's valuation, as future cash flows are discounted at a lower rate.
Tax shields play a pivotal role in corporate finance strategy. They not only provide immediate tax savings but also influence a company's capital structure and investment decisions. By understanding and utilizing tax shields effectively, companies can optimize their WACC and enhance shareholder value.
The Basics of Tax Shield - Tax Shield: Understanding the Tax Shield s Impact on WACC
The concept of a tax shield is a critical component in the analysis of a company's financial decisions, particularly when it comes to understanding the impact on the Weighted average Cost of Capital (WACC). A tax shield refers to the reduction in income taxes that results from taking an allowable deduction from taxable income. In the context of WACC, the tax shield is most commonly associated with the deductibility of interest on debt, which lowers the effective cost of borrowing and thus impacts the overall cost of capital for a company.
From a financial analyst's perspective, calculating the tax shield is a straightforward process, but its implications are far-reaching. The tax shield effectively serves as a subsidy on debt, making it cheaper for companies to finance their operations through borrowing rather than through equity. This can lead to a range of strategic financial decisions, including capital structure optimization and leveraged buyouts.
Here's how to calculate the tax shield and its impact on WACC:
1. Identify the Deductible Expenses: The first step is to identify which expenses are tax-deductible. Interest expenses on debt are the most common source of tax shields. For example, if a company has $1 million in interest expenses and the corporate tax rate is 30%, the tax shield for that year would be $300,000.
2. Calculate the tax shield: The tax shield is calculated by multiplying the deductible expense by the corporate tax rate. Using the formula $$ Tax\ Shield = Deductible\ Expense \times Tax\ Rate $$, we can determine the tax shield on the interest expense.
3. Adjust the cost of debt: Once the tax shield is calculated, it is used to adjust the cost of debt. The after-tax cost of debt is calculated as $$ After-Tax\ Cost\ of\ Debt = Cost\ of\ Debt \times (1 - Tax\ Rate) $$. This reflects the fact that the government is effectively paying a portion of the interest expense.
4. Incorporate into WACC: The WACC is calculated using the formula $$ WACC = \frac{E}{V} \times Re + \frac{D}{V} \times Rd \times (1 - Tc) $$ where \( E \) is the market value of equity, \( V \) is the total market value of equity and debt, \( Re \) is the cost of equity, \( D \) is the market value of debt, \( Rd \) is the cost of debt, and \( Tc \) is the corporate tax rate. The tax shield is incorporated through the \( (1 - Tc) \) term applied to the cost of debt.
Example to Highlight the Concept:
Imagine a company, XYZ Corp, has a cost of debt at 5% and a corporate tax rate of 30%. Without considering taxes, the cost of debt is simply 5%. However, with the tax shield, the after-tax cost of debt is reduced to 3.5% (5% * (1 - 0.30)). This reduction in the cost of debt will lower the WACC, making it cheaper for XYZ Corp to undertake projects financed through debt.
The tax shield plays a pivotal role in corporate finance by affecting the cost of capital. It incentivizes the use of debt financing over equity, which can lead to a more efficient capital structure if managed properly. However, it's important to balance the benefits of a tax shield with the risks associated with increased leverage, such as financial distress and bankruptcy costs. Financial analysts and corporate managers must carefully consider these factors when making financing decisions.
Calculating the Tax Shield - Tax Shield: Understanding the Tax Shield s Impact on WACC
The Weighted Average Cost of Capital (WACC) represents a firm's blended cost of capital across all sources, including both debt and equity. Financial analysts use WACC widely as a threshold rate for investment appraisal to determine the economic feasibility of expansionary opportunities and mergers or acquisitions. It's not just a measure of the cost of capital but also a crucial indicator of the risk associated with the firm's operational framework.
From the perspective of an investor, WACC is pivotal in estimating the return on investment. A lower WACC indicates that a company can generate value at a lower cost, thus providing a higher margin of safety for the investor. Conversely, from a corporate finance standpoint, a lower WACC means that the company can undertake more projects that yield a return higher than the cost of capital, leading to growth and expansion.
Here are some in-depth insights into WACC:
1. Components of WACC: The formula for WACC is $$ WACC = \frac{E}{V} \times Re + \frac{D}{V} \times Rd \times (1 - Tc) $$ where \( E \) is the market value of the equity, \( V \) is the total market value of equity and debt, \( Re \) is the cost of equity, \( D \) is the market value of the debt, \( Rd \) is the cost of debt, and \( Tc \) is the corporate tax rate. This formula highlights the proportionate cost of each component of capital, factoring in the tax shield provided by deductible interest expenses.
2. Risk and Return: The cost of equity (\( Re \)) is typically higher than the cost of debt (\( Rd \)), reflecting the higher risk that equity investors bear compared to debt holders. Equity holders are last in line during liquidation, and their returns are not guaranteed, unlike debt holders who receive fixed interest payments.
3. Tax Shield: The tax deductibility of interest makes debt a cheaper source of finance, which is why the cost of debt is multiplied by \( (1 - Tc) \) in the WACC formula. This 'tax shield' reduces the overall cost of capital, making it advantageous for companies to structure their finances with a mix of debt and equity.
4. Investment Decisions: Companies use the WACC as a discount rate for calculating the Net Present Value (NPV) of potential projects. If the NPV is positive, the project is expected to generate a return higher than the cost of capital, justifying the investment.
5. Impact on Valuation: WACC is also used in the discounted Cash flow (DCF) method of valuation. A lower WACC increases the present value of future cash flows, raising the valuation of a company.
To illustrate the importance of WACC, consider a company evaluating two projects: Project A with an expected return of 12% and project B with 8%. If the company's WACC is 10%, Project A would be accepted (since 12% > 10%), while Project B would be rejected (since 8% < 10%). This simple example underscores how WACC serves as a benchmark for making strategic financial decisions.
WACC is not just a dry financial metric; it embodies the risk-return tradeoff inherent in the capital structure of a company. It influences strategic decisions, from funding operations to pursuing new ventures, and ultimately shapes the company's trajectory towards growth and shareholder value creation.
Definition and Importance - Tax Shield: Understanding the Tax Shield s Impact on WACC
Incorporating the concept of a tax shield into the Weighted Average Cost of Capital (WACC) is a critical aspect of financial analysis, particularly when assessing the value of a company. The tax shield refers to the reduction in income taxes that results from taking allowable deductions from taxable income. In the context of WACC, the tax shield is most commonly associated with the deductibility of interest expenses on debt. This deduction effectively reduces the cost of debt, as the interest payments are made with pre-tax dollars, thus providing a 'shield' against taxes.
From a corporate finance perspective, the tax shield is an essential factor in capital structure decisions. It influences the proportion of debt and equity a company uses to finance its operations and investments. The tax shield's impact on WACC is significant because it lowers the after-tax cost of debt, which is a component of WACC. By reducing the overall cost of capital, a tax shield can increase the value of a company, as it allows for more investment opportunities with positive net present values (NPVs).
1. Calculation of WACC with Tax Shield:
To calculate WACC incorporating the tax shield, the formula is:
$$ WACC = \frac{E}{V} \times Re + \frac{D}{V} \times Rd \times (1 - Tc) $$
Where:
- \( E \) = Market value of the equity
- \( V \) = Total value of capital (equity + debt)
- \( Re \) = Cost of equity
- \( D \) = Market value of the debt
- \( Rd \) = Cost of debt
- \( Tc \) = Corporate tax rate
The term \( \frac{D}{V} \times Rd \times (1 - Tc) \) represents the after-tax cost of debt, reflecting the tax shield's effect.
2. impact on Investment decisions:
A lower WACC due to the tax shield means that a company can undertake additional projects that previously may not have met the required rate of return. For example, if a company's WACC without the tax shield is 8%, but with the tax shield it drops to 6%, projects that yield a return between 6% and 8% now become viable.
3. Differing Perspectives on Tax Shield Valuation:
- Traditional View: This view holds that the tax shield should be valued as a safe, risk-free asset because tax savings are guaranteed as long as the company has sufficient earnings before interest and taxes (EBIT) to cover the interest expenses.
- Modigliani-Miller Proposition: Under the modigliani-Miller framework, assuming no bankruptcy costs and perfect capital markets, the tax shield is valued in the same way as debt.
- Adjusted Present Value (APV) Approach: This method separates the value of the tax shield from the value of the levered firm and discounts the tax shield at the risk-free rate, reflecting its lower risk compared to the firm's assets.
4. Real-World Example:
Consider a company with a cost of equity of 10%, a pre-tax cost of debt of 5%, a corporate tax rate of 30%, and a capital structure consisting of 40% debt and 60% equity. The WACC, incorporating the tax shield, would be:
$$ WACC = \frac{60\%}{100\%} \times 10\% + \frac{40\%}{100\%} \times 5\% \times (1 - 30\%) = 6\% + 1.4\% = 7.4\% $$
This WACC can be used to evaluate the company's potential investment projects and strategic decisions.
The tax shield's incorporation into WACC is a nuanced process that requires careful consideration of the tax implications of debt financing. It is a powerful tool in the hands of financial analysts and corporate decision-makers, enabling them to make more informed decisions about the company's financial strategy and investments.
The concept of a tax shield is a fundamental aspect of corporate finance, particularly when it comes to understanding its influence on the Weighted average Cost of Capital (WACC). A tax shield refers to the reduction in income taxes that a firm can achieve through the use of various deductions, such as interest expenses. This reduction in taxable income ultimately leads to a lower tax payment, which can have a significant impact on a company's cash flow and valuation. The real-world implications of tax shields are vast and multifaceted, affecting decisions ranging from investment strategies to corporate structuring.
From a financial analyst's perspective, the tax shield is a critical component in valuing companies and assessing their financial health. For instance, when a company takes on debt, the interest payments are tax-deductible, which lowers the company's taxable income and thus its tax liability. This effect increases the value of debt in a company's capital structure, as the cost of debt is effectively reduced by the tax rate. To illustrate:
1. interest Tax shield: If a company has an interest expense of $1 million and a corporate tax rate of 30%, the tax shield for that period would be $300,000 ($1 million * 30%). This means that the company's tax bill is reduced by that amount, which is a direct addition to the cash flow.
2. depreciation Tax shield: depreciation is a non-cash expense that reduces taxable income. For example, if a company purchases equipment for $5 million with a useful life of 5 years, it can depreciate $1 million each year. If the tax rate is 30%, this results in a yearly tax shield of $300,000.
From an investor's point of view, the tax shield is a component of the company's value creation. Investors look at the effective tax rate and the strategies a company employs to maximize its tax shield, as these can significantly affect the company's net income and free cash flow, which are key determinants of stock prices.
For corporate managers, understanding and optimizing the tax shield can lead to more informed strategic decisions. For example, a company considering a large capital investment might opt for debt financing over equity to take advantage of the interest tax shield, thereby lowering the WACC and increasing the project's net present value (NPV).
real-world examples of tax shield impact include:
- Apple Inc.: In 2013, Apple issued bonds worth billions of dollars despite having ample cash reserves. This move was partly to benefit from the interest tax shield, as repatriating cash held overseas would have incurred higher taxes.
- real estate Investment: real estate investors often use mortgage financing to purchase properties, not only because it allows for leverage but also because the interest paid on the mortgage provides a tax shield, enhancing the investment's overall return.
The tax shield's impact on WACC is a testament to the intricate interplay between taxation and corporate finance. By reducing the cost of capital, tax shields play a pivotal role in investment decisions and the overall financial strategy of a company. understanding its real-world impact is essential for analysts, investors, and managers alike, as it directly influences the financial modeling and valuation processes that drive economic growth and corporate success. The strategic use of tax shields can lead to significant competitive advantages and is a testament to the nuanced nature of financial decision-making in the business world.
Tax Shields Real World Impact - Tax Shield: Understanding the Tax Shield s Impact on WACC
The concept of a tax shield is a critical component in the analysis of a company's financial strategy, particularly when evaluating the cost of capital. A tax shield refers to the reduction in income taxes that results from taking an allowable deduction from taxable income. For businesses, the most common tax shields are derived from interest expenses, depreciation, and amortization. These deductions can significantly affect a company's weighted average cost of capital (WACC), which is the average rate a company expects to pay to finance its assets.
When considering the impact of a tax shield on WACC, it's essential to understand that WACC represents the minimum return a company must earn on its existing asset base to satisfy its creditors, owners, and other capital providers. The presence of a tax shield can lower the WACC, making it cheaper for a company to fund new projects or investments. This is because the tax shield effectively reduces the cost of debt, which is a component of WACC.
1. Without Tax Shield:
In a scenario without a tax shield, the entire interest expense is borne by the company, which increases the cost of debt. Consequently, the WACC is higher as it does not benefit from the tax deductibility of interest payments. For example, if a company has a cost of debt at 7% and faces a corporate tax rate of 30%, without the tax shield, the after-tax cost of debt would remain at 7%.
2. With Tax Shield:
Conversely, with a tax shield, the interest expense is deducted from taxable income, which lowers the tax liability. The after-tax cost of debt is calculated as the cost of debt multiplied by (1 - tax rate). Using the same figures as above, with a tax shield, the after-tax cost of debt would be 4.9% (7% * (1 - 0.30)). This reduction in the cost of debt leads to a lower WACC.
3. Comparative Analysis:
To illustrate the comparative impact, let's consider a company with a simple capital structure of 50% equity and 50% debt, a cost of equity of 10%, and a pre-tax cost of debt of 7%. Without a tax shield, the WACC would be calculated as follows:
$$ WACC = \frac{Equity}{Equity + Debt} \times cost\ of\ equity + \frac{Debt}{Equity + Debt} \times Cost\ of\ Debt $$
$$ WACC = \frac{0.5}{1} \times 10\% + \frac{0.5}{1} \times 7\% = 5\% + 3.5\% = 8.5\% $$
With a tax shield at a 30% tax rate, the WACC would be:
$$ WACC = \frac{0.5}{1} \times 10\% + \frac{0.5}{1} \times (7\% \times (1 - 0.30)) = 5\% + 2.45\% = 7.45\% $$
The comparative analysis shows a clear reduction in WACC from 8.5% to 7.45% due to the tax shield. This reduction enhances the company's ability to pursue additional investments at a lower cost, potentially leading to increased shareholder value.
4. Broader Implications:
From an investor's perspective, companies with significant tax shields may be more attractive as they can utilize their capital more efficiently. However, it's also important to consider the stability of the tax shield benefits, as changes in tax laws or company profitability can alter the effectiveness of these shields.
The presence of a tax shield has a tangible impact on a company's WACC, influencing its financial strategy and investment decisions. By lowering the cost of debt, a tax shield can lead to a more favorable WACC, providing the company with a competitive advantage in capital allocation and value creation. It's a nuanced aspect of corporate finance that requires careful consideration from both management and investors alike.
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strategic financial planning is a critical component for any business seeking to maximize its value and ensure long-term sustainability. One often overlooked aspect of this planning is the utilization of a tax shield, which can significantly impact a company's weighted average cost of capital (WACC). A tax shield refers to the reduction in income taxes that results from taking allowable deductions from taxable income. In the context of WACC, the tax shield is particularly relevant as it affects the cost of debt, which is a component of this calculation. By understanding and strategically using tax shields, companies can effectively lower their WACC, thereby reducing their hurdle rate for investment and potentially unlocking greater value for shareholders.
From the perspective of a CFO, the tax shield is a tool for optimizing the capital structure. The interest expense on debt is tax-deductible, which means that by increasing the proportion of debt in the company's capital structure, the overall tax liability can be reduced. This, in turn, lowers the cost of debt after taxes, which is factored into the WACC. For example, if a company has a 30% corporate tax rate and pays $1 million in interest, the tax shield would save the company $300,000 in taxes ($1 million * 30%).
However, from a risk management standpoint, over-leveraging to capitalize on the tax shield can backfire. Excessive debt can lead to financial distress and increase the company's risk profile, which might raise the cost of both debt and equity. Therefore, it's crucial to strike a balance between the benefits of the tax shield and the risks associated with high levels of debt.
Here are some in-depth points to consider when strategically planning financials using the tax shield:
1. Assessing the Optimal Debt Level: Determine the amount of debt that maximizes the tax shield without excessively increasing the company's risk of default.
2. evaluating Interest rates: Monitor the market interest rates to decide the most opportune times to incur debt, as lower rates will enhance the benefits of the tax shield.
3. Diversifying Capital Sources: Consider a mix of long-term and short-term debt to take advantage of different interest rate environments and repayment structures.
4. projecting Future earnings: Forecast the company's earnings to ensure that it will generate enough profit to benefit from the tax deductions associated with debt interest.
5. Understanding Tax Legislation: Stay informed about changes in tax laws that may affect the value of the tax shield and adjust the financial strategy accordingly.
For instance, a company planning to invest in new machinery could opt to finance the purchase through debt rather than using equity. If the machinery costs $5 million and the company finances it with a loan at a 5% interest rate, the annual interest expense would be $250,000. With a 30% tax rate, the tax shield would save the company $75,000 a year in taxes, effectively reducing the cost of the machinery.
Strategic financial planning using the tax shield requires a multifaceted approach that considers the company's capital structure, market conditions, and tax environment. By leveraging the tax shield effectively, companies can reduce their WACC, making investments more attractive and enhancing shareholder value. It's a delicate balance that requires careful analysis and foresight, but when done correctly, it can be a powerful tool for financial optimization.
Strategic Financial Planning Using Tax Shield - Tax Shield: Understanding the Tax Shield s Impact on WACC
The concept of a tax shield plays a pivotal role in financial analysis, particularly when assessing the cost of capital through the Weighted average Cost of Capital (WACC). The tax shield, essentially the savings in taxes due to deductible expenses and depreciation, can significantly affect a company's cash flow and investment strategy. As we look to the future, the relevance and application of tax shields in financial analysis are poised to evolve in response to changing tax laws, financial innovation, and the global economic landscape.
From the perspective of corporate finance, the tax shield is a critical component in optimizing capital structure. By understanding the tax implications of interest payments on debt, companies can strategically leverage debt to minimize their WACC, thereby increasing the value of the firm. For instance, consider a company with a high tax rate that opts for debt financing over equity. The interest payments on the debt are tax-deductible, leading to a tax shield that effectively reduces the company's taxable income and, consequently, its tax liability. This reduction in taxes enhances the company's net income and cash flow, providing more resources for reinvestment or distribution to shareholders.
However, the future of tax shields in financial analysis is not without its complexities. Here are some key points to consider:
1. Regulatory Changes: Tax codes are subject to change, and shifts in policy can alter the attractiveness of debt financing. For example, if tax rates were to decrease significantly, the value of the tax shield would diminish, potentially prompting firms to reevaluate their debt levels.
2. interest Rate fluctuations: The benefit of a tax shield is also tied to interest rates. In a low-interest-rate environment, the cost of debt is reduced, making the tax shield more valuable. Conversely, rising interest rates can increase the cost of debt, diminishing the tax shield's impact.
3. Economic Cycles: During economic downturns, companies may face reduced profitability, limiting their ability to utilize tax shields effectively. Conversely, in a booming economy, the increased earnings can be offset by the tax shield, providing a buffer against higher tax liabilities.
4. International Considerations: Multinational corporations must navigate varying tax regimes, which can complicate the calculation and utilization of tax shields. transfer pricing and tax treaties play a significant role in determining the optimal capital structure for these firms.
5. Financial Innovation: New financial instruments and strategies may emerge, offering alternative ways to create or enhance tax shields. For example, hybrid securities that blend characteristics of debt and equity could provide novel tax advantages.
To illustrate these points, let's take the example of a multinational corporation that operates in multiple countries with different tax rates and regulations. The company must carefully analyze each jurisdiction to determine the most tax-efficient way to finance its operations. In one country, it might be advantageous to use more debt to capitalize on a high tax rate and the resulting tax shield. In another, with lower tax rates or restrictions on interest deductibility, the company might opt for equity financing instead.
The future of tax shields in financial analysis is likely to be characterized by a greater need for agility and adaptability. Financial managers will need to stay abreast of regulatory changes, economic trends, and financial innovations to effectively leverage tax shields in their capital structure decisions. As the business environment continues to evolve, so too will the strategies for maximizing the benefits of tax shields, ensuring they remain a key consideration in the pursuit of optimal financial performance.
Future of Tax Shield in Financial Analysis - Tax Shield: Understanding the Tax Shield s Impact on WACC
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