Question

1. A firm has a cost of equity of 13 percent, a cost of preferred of 5 percent, an after-tax cost of debt of 3.4 percent and a tax rate of 21%. Given this, which of the following will increase the firm’s weighted average cost of capital?
   1. Increase the firm’s tax rate
   2. Issuing new bonds at par
   3. Increasing the firm’s beta
   4. Increasing the debt/equity ratio

1. Which of the following will decrease the after-tax cost of debt for a firm?
   1. Decrease in the firm’s beta
   2. Increase in tax rates
   3. Increase in the risk-free rate of return
   4. Decrease in the market price of the debt

1. The common stock of Contemporary Interiors has a beta of 1.13 and a standard deviation of 21.4 percent. The market rate of return is 12.7 percent and the risk-free rate is 4.1 per cent. What is the cost of equity for the firm?
   1. 13.82 percent
   2. 11.76 percent
   3. 12.08 percent
   4. 14.40 percent

Answer 1

The answer is

1. Increasing the firm’s beta

Increase in tax rate will reduce WACC as tax benefit is available on debt

Issuing bonds will increase debt and hence lower WACC since cost of debt is lower

Increasing the debt/equity ratio will increase debt and hence lower WACC since cost of debt is lower

1. Increase in tax rates

As after tax cost of debt = before tax cost*(1-tax rate)

Cost of Equity as per CAPM = risk free rate + beta*(Market return – risk free return)

= 4.1% + 1.13*(12.7%-4.1%)

= 13.818%

i.e. 13.82%