Question

If a company's target capital structure is 50% debt and 50% common equity, which would be a correct statement? Question 3 options:

a) The cost of reinvested earnings typically exceeds the cost of new common stock.

b) The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.

c) The WACC is calculated on a before-tax basis.

d) The cost of equity is always equal to or greater than the cost of debt.

Answer 1

Option"D" is correct, i.e., The cost of equity is always equal to or greater than the cost of debt because

Debt is a contractual obligation between a company and its creditors. The contract outlines the repayment of borrowed money typically with interest or fees to the creditors in payment for the use of that capital. The legal contract between creditor and company always places the creditors repayment rights above those of any distributions to equity holders.

Equity holders will never accept a return on investment that is lower than debt holders. This is because equity holders are always subordinate to debt holders and do not receive a contractual obligation to be repaid their capital.

If this offer existed, then equity investors would simply purchase the debt since it offers superior protection on their capital and superior returns in comparison to the equity investment.