Which of the following statements is CORRECT? Answer When calculating the cost o

Question

Which of the following statements is CORRECT?
Answer
When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible
by the paying corporation.
Because of tax effects, an increase in the risk-free rate
will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
If a company

Explanation / Answer

Correct
When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible
by the paying corporation.
Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company’s WACC.

Incorrect
Because of tax effects, an increase in the risk-free rate
will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock.

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