Question

Firm M's earnings and stock price tend to move up and down with other firms in...

Firm M's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm W's earnings and stock price move counter cyclically with M and other S&P companies. Both M and W estimate their costs of equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only with common equity. Which of the following statements is CORRECT?

a. Since M and W move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs.
b. Without additional information, it is impossible to predict what the merged firm's WACC would be if M and W merged.
c. M and W should have identical WACCs because their risks as measured by the standard deviation of returns are identical.
d. If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs.
e. M should have the lower WACC because it is like most other companies, and investors like that fact.
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Answer #1

Answer:- Option (d):  If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs.

Explanation:- As firm M's earnings and stock price moves up and down with other firms in the S&P 500 and on the other hand Firm W's earnings and stock price move counter cyclically with M and other S&P companies, so in this case if Firm M and Firm W are merged, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs.

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