Question

How would each of the following scenarios affect a firm’s cost of debt, rd (1 –T); its cost of equity, rs; and its WACC? Indicate with a plus +, a minus −, or a zero 0whether the factor would raise, lower, or have an indeterminate effect on the item in question. Assume for each answer that other things are held constant, even though in some instances this would probably not be true. Justify your answers in brief sentences in areas below each scenario.

Scenarios: Probable Effect on

rd (1 – T)

rs

WACC

a. The corporate tax rate is lowered.

b. The firm expands into a risky new area.

c. The firm merges with another firm whose earnings are countercyclical both to those of the first firm and to the stock market.

d. Investors become more riskaverse.

Answer 1

A . The cost of debt is lowered due to lowering of of corporate tax. As the cost of debt lowers the wacc also decreases.

B. If the firm expands into risky new area the beta of the cost of capital goes up . This increases the cost of equity and cost of debt thereby the WACC.

C. There is no effect on earnings on the cost of capital.

D. The investors become more risk averse meaning the company had to incur more to service debt and maintain capital. This increases the cost of debt, cost of capital and WACC.