Which of the following statements is CORRECT? When calculating the cost of debt,
ID: 2730815 • Letter: W
Question
Which of the following statements is 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.
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.
Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC.
a)When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
b)When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
c)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.
d)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.
e)Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC.
Explanation / Answer
Ans a) True
When calculating the cost of debt, a company needs to adjust for taxes, because interest payments
Are deductible by paying corporation.
False
b) Cost of Preferred stock is the rate of return required by the holders of the company’ Preferred stock. It is calculating by dividing the annual dividend payment on the preferred stock by the preferred stock’ current market price.
c) The capital assets pricing model is a model that describe the relationship between risk and expected return.
d) Company’s beta worked in the opposite direction, if beta increases share prices decreases.
e) Floatation cost are the cost which is incurred by the company when it issues new securities. Floatation cost is an expense, floatation costs, expected return on equity ,dividend payment, the percentage of earnings the company expects to retain ,helps to calculate company new cost of equity.
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