Question

Which of the following statements is CORRECT?

a. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.

b. If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.

c. Higher flotation costs tend to reduce the cost of equity capital.

d. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.

e. Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt.

Answer 1

Statement a is incorrect because tax adjusted cost of debt will always be less than the interest rate on debt. The formula for after tax cost of debt= r_d*(1-t) where r_d is cost of debt or interest and t is the tax bracket of the company.

Statement b is correct as a riskier project will have a higher beta and thus it's expected return will be more and a less risky project will have a lower value of beta and thus it's expected rate of return will be less.(expected return can be calculated through CAPM formula = R_f + beta*(R_mkt - R_f) where R_f is risk free rate, beta is the measure of risk and R_mkt is return in market for similar risky investment). A project is accepted when expected return is more than the cost of capital. A riskier project must have a higher cost of capital as the company needs to pay higher cost to compensate for higher risk but by assigning same cost we would have a lower WACC and thus the difference between the expected return would be positive. Similar thing happens if we do not reduce our WACC on a low risk investment as the cost of capital will be higher and thus the difference between the expected rate and wacc will be negative and we will reject it even when it could have been a profitable investment.

Statement c is incorrect as cost of equity increases with increase in flotation cost. Flotation cost is the additional cost for issuing the equity like fees to the brokers and thus this would get included to the cost of the equity.

Statement d is incorrect because debt, being a liability, has to be paid by the company and if the company is unable to pay the debt it will go bankrupt and its assets will be sold to pay the debt holders. This means a debt holder will be paid no matter what and thus the risk involved with a debt is least. The finance world works in the principle of "more risk yields more return" and thus the debt holder gets the least return which means the company has to pay least return to its debt holders and this is why a debt is less costly than equity for a company. As the interest on a debt is tax deductible, this further lowers the cost of debt for the companies.

Statement e is incorrect because, even though there is no flotation cost involved with reinvesting earnings, the retained earnings are opportunity costs for the investors because if the company would have not retained it, it would have been distributed to the investors in the form of dividend and they would have invested that money in the market to get some return. Thus the cost of retained earnings should be equal to the cost of equity or to the return on investment on securities with similar risk (which will always be higher than the after tax cost of debt).