Question

Burnham Brothers Inc. has no retained earnings since it has always paid out all of its earnings as dividends. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?

Group of answer choices:

A. The market risk premium declines.

B. The flotation costs associated with issuing new common stock increase.

C. The company's beta increases.

D. Expected inflation increases.

E. The flotation costs associated with issuing preferred stock increase.

Answer 1

Answer: Option A

WACC is reduced when cost of the component capital declines. When market risk premium declines (as in option A), cost of common equity would decrease and hence WACC would decrease as well.

In option B and E, floatation costs would increase the cost of components and hence increase WACC.

In option C, based on CAPM, cost of equity increases and hence WACC increases as well.

In option D, expected inflation would increase the cost of debt and hence WACC would increase as well.