Question

How would each of the following scenarios affect a firms cost of debt , Rd (1-T) , its cost of equity, Rs, and its WACC. Indicate with a (+), a minus (-), or a zero (0) whether the factor would raise , lower, or have indeterminate effect on the item in question. Assume for each answer that other things are held constant, even though in some instances this would probably not be true. Be prepared to justify your answer but recognize that several of the parts have no single correct answer. These questions are designed to stimulate thought and discussion.

Please Indicate a (+), (-), or (0) for the effect on a firms cost of debt , Rd (1-T) , its cost of equity, Rs, and its WACC

a The corporate tax rate is lowered.

b The federal reserve tightens credit.

c The firm uses more debt, that is, it increases its debt ratio.

d The dividend payout ratio is increased.

e The firm doubles the amount of capital it raises during the year.

f The firm expands into a risky new area.

g The firm merges with another firm whose earnings are counter-cyclical both to those of the first firm and to the stock market.

h The stock market falls drastically and the firms stock price falls along with the rest.

I Investors become more risk averse.

j The firm is an electric utility with a large investment in nuclear plants. Several states are considering a ban on nuclear power generation.

Answer 1

WACC = ((E/V) * R_e) + [((D/V) * R_d)*(1-T)]

E = Market value of the company's equity
D = Market value of the company's debt
V = Total Market Value of the company (E + D)
R_e = Cost of Equity
R_d = Cost of Debt
T= Tax Rate

		EFFECT ON
		rd(1-T)	rs	WACC	Justification
a	The corporate tax is lowered	+	0	+	corporate income tax rate goes down, company's WACC goes up since a lower tax rate produces a lesser tax shield
b	The Federal reserve tightens credit	+	+	+	When the Fed raises interest rates, the risk-free rate immediately increases. A higher cost of capital for the company might also increase the risk that it will default. That would raise the default premium and further increase the interest rate used for the WACC
c	The firm uses more debt.	+	+	0	If more debt is used,the equity cost will also increase
d	The dividend payout ratio is increased	0	0	0	Increase in Dividend payout has no effect on cost of capital
e	The firm doubles the amount of capital,     it raises during the year.	0 or +	0 or +	0 or +	It may or may not change the cost of capital
f	The firm expands into a risky new area.	+	+	+	Expansion of new risky areas involves new finance and the costs will increase
g	The firm merges with another firm whose earnings are counter-cyclical both to those of the first firm and to the stock market.	-	-	-	It will negatively affect the company as both companies cost are opposite
h	The stock market falls drastically and the firms stock price falls along with the rest	0	+	+	it won't affect debt but cost of equity and wacc will increases due to the risk in equity in capital
i	Investors become more risk averse.	+	+	+	The risk will be higher and cosT of equity, debt and wacc will be more
j	The firm is an electric utility with a large investment in nuclear plants. Several states are considering a ban on nuclear power generation.	+	+	+	This investment is highly risk and raises all capital