Which of the following statements is CORRECT? a. An increase in the risk-free rate is likely...

Which of the following statements is CORRECT?

a. An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity.

b. The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure.

c. The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used.

d. Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm's stockholders are well diversified.

e. The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal or is available online.

Expert Solution

The following statement, among those given, is CORRECT:

“The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure.”

The answer is option b.

Regarding other options which are not correct:

a. Increase in the risk-free rate will increase (and not decrease) the marginal costs of both debt and equity.

c. The WACC is calculated using after-tax cost (and not before-tax cost), along with the costs for common stock and for preferred stock if it is used.

d. Beta measures the degree of change of return in relation to the market risk premium (and not the the market risk premium as such).

e. The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the YTM (and not interest rate) on the company's own long-term bonds.

jeff jeffy answered 2 years ago

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