Question

Which of the following statements is correct?

a. Because we often need to make comparisons among firms that are in different income tax brackets, it is best to calculate the WACC on a before-tax basis.

b. If a firm has been suffering accounting losses and is expected to continue suffering such losses, and therefore its tax rate is zero, it is possible that its after-tax component cost of preferred stock as used to calculate the WACC will be less than its after-tax component cost of debt.

c. Due to the way the MCC is constructed, the first break point in the MCC schedule must be associated with using up all available retained earnings and having to issue common stock.

d. Normally, the cost of external equity raised by issuing new common stock is above the cost of retained earnings. Moreover, the higher the growth rate is relative to the dividend yield, the more the cost of external equity will exceed the cost of retained earnings.

e. The lower a company's tax rate, the greater the advantage of using debt in terms of lowering its WACC.

Answer 1

The correct statement is

d. Normally, the cost of external equity raised by issuing new common stock is above the cost of retained earnings. Moreover, the higher the growth rate is relative to the dividend yield, the more the cost of external equity will exceed the cost of retained earnings.

Since cost of external equity involves flotation cost which is not incurred in retained earnings

Higher the tax rate, the greater the advantage of using debt

Since interest on debt gets tax advantage while dividend does not

Hence, e is false

a is false, it should be compared on after tax basis