Question

Franklin Inc. has no retained earnings and expects to pay out all of its earnings as dividends in the future. Now the company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would INCREASE its weighted average cost of capital (WACC), except:

a. The market risk premium increases

b. The company’s beta is higher than the benchmark in the industry due to a new R&D project

c. Federal Reserve Bank recently issued a 30-year Treasury bond with a lower interest rate

d. The cost of issuing preferred stock increases

e. With the new Tax Reform, Franklin Inc. now has greater tax shield. Its overall corporate tax for the coming year is reduced by 0.5%.

Answer 1

A firm’s WACC increases as the beta and rate of return on equity increase, because an increase in WACC denotes a decrease in valuation and an increase in risk.Depending on how the relative use of debt or common equity is affected, issuing preferred stock may increase and decrease a company's WACC in the immediate term. But the longer term net effect may be uncertain, because many other factors do not remain constant following the change in capital structure. A decrease in debt-to-equity ratio by using more preferred stock could have a positive effect on the company over the long run. Less financial leverage can reduce overall risk and may cause WACC to go down over time. On the other hand, the increased use of preferred stock relative to common equity might expose a company to higher financial risk because of its preferred-dividend obligation. Therefore, the immediate benefit of lowering WACC from issuing preferred stock may disappear over time, and WACC may go up gradually.

Therefore, (d)The cost of issuing preferred stock increases is the event which would reduce weighted average cost of capital (WACC).