How would each of the following affect a firm’s cost of debt, rd(1 T); its cost
ID: 2740132 • Letter: H
Question
How would each of the following affect a firm’s cost of debt, rd(1 T); its cost of equity, rs; and its WACC? Indicate by a plus (), a minus (), or a zero (0) if the factor would raise, lower, or have an indeterminate effect on the item in question. Assume for each answer that other things are held constant, even though in some instances this would probably not be true. Be prepared to justify your answer, but recognize that several of the parts have no single correct answer; these questions are designed to stimulate thought and discussion.
EFFECT ON
rd(1 T) rs WACC
a. The corporate tax rate is lowered. ______ ______ ______
b. The Federal Reserve tightens credit. _____ ______ ______
c. The firm uses more debt; that is, it
increases its debt/assets ratio. ______ ______ ______
d. The dividend payout ratio is increased. ______ ______ ______
e. The firm doubles the amount of
capital it raises during the year. ______ ______ ______
f. The firm expands into a risky new area. ______ ______ ______
g. The firm merges with another firm
whose earnings are countercyclical
both to those of the first firm and to
the stock market. ______ ______ ______
h. The stock market falls drastically, and
the firm’s stock price falls along with
the rest. ______ ______ ______
i. Investors become more risk averse. ______ ______ ______
j. The firm is an electric utility with a
large investment in nuclear plants.
Several states are considering a ban on
nuclear power generation. ______ ______ ______
Explanation / Answer
Cost of debt Cost of equity WACC The corporate tax rate is lowered + 0 + The Federal Reserve tightens credit 0 0 0 The firm uses more debt; that is, it increases its debt/assets ratio + + + The dividend payout ratio is increased 0 + + The firm doubles the amount of capital it raises during the year + + + The firm expands into a risky new area 0 + + The firm merges with another firm whose earnings are countercyclical both to those of the first firm and to the stock market. + + + The stock market falls drastically, and the firm’s stock price falls along with the rest + + + Investors become more risk averse 0 + + The firm is an electric utility with a large investment in nuclear plants. Several states are considering a ban on nuclear power generation 0 + +
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