Question

Which of the following statements is/are true?  

Multiple Choice

• A. All else held constant, if a company has a beta of 1.2, then the cost of equity for this company will increase if the risk-free rate decreases.

• B. If you assume a company has debt, then an increase in the tax rate will decrease the weighted average cost of capital for the company.

• Both A and B are true.

• Neither A nor B are true.

Answer 1

Using CAPM, expected return on stock is

E(r) = Rf + beta*(Rm - Rf)

at beta = 1.2

E(r) = Rf + 1.2*(Rm - Rf) = 1.2*Rm - 0.2*Rf

So, if risk free rate Rf decreases in the above formula, E(r) will increase hence statement A is correct.

Weighted average cost of capital is found using formula

WACC = Wd*Kd*(1-T) + We*Ke

When tax rate T increase, first term of the formula decreases. If everything else is constant, WACC will decrease. So, statement is correct.

Hence Both A and B are true.