1. (True/False): A firm\'s cost of capital will generally increase if the firm l
ID: 2754281 • Letter: 1
Question
1. (True/False): A firm's cost of capital will generally increase if the firm lowers its debt-equity ratio.
2. (True/False): The cost of equity will generally increase for risky firms when the risk-free rate of return increases.
3. To calculate the present value of a business, the firm's free cash flows should be discounted at the firm's:
A. weighted-average cost of capital.
B. pre-tax cost of debt.
C. aftertax cost of debt.
D. cost of equity.
4. An increase in which one of the following is most apt to decrease the WACC of a firm that has both debt and equity in its capital structure?
A. Firm's beta
B. Market rate of return
C. Tax rate
D. Yield on preferred stock
Explanation / Answer
1. A firm's cost of capital will generally increase if the firm lowers its debt-equity ratio :True. This is because debt financing generally allows tax deductibility. Hence, offers the lowest cost of capital.
2. The cost of equity will generally increase for risky firms when the risk-free rate of return increases:False
The cost of equity will generally remain unchanged for risky firms when the risk-free rate of return increases.
This can be ascertained using the Capital Asset Pricing Model (CAPM) by the formula:
Cost of Equity (Kc)= Rf + (Rm-Rf) B
Where, Rf is the risk free return
Rm = Return from the market
B= Beta.
3. To calculate the present value of a business, the firm's free cash flows should be discounted at the firm's:
C. aftertax cost of debt. This is because tax implications are taken into consideration.
4. An increase in C. Tax Rate is the most apt to decrease the WACC of a firm that has both debt and equity in its capital structure.
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