Question

Burnham Brothers Inc. has no retained earnings since it has always paid out all of its earnings as dividends. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?

	a.	Expected inflation increases.
	b.	The flotation costs associated with issuing preferred stock increase.
	c.	The company's beta increases.
	d.	The tax rate increases.
	e.	The market risk premium increases.

Answer 1

Answer to the question :

a) Inflation Increase - When the expected inflation increase it results in INCREASE in  WACC because as a result of inflation, interest rate increases.

b) Floatation cost - Increse in floatation cost associated with issue of the preferred stock results in INCREASE IN WACC beacause as a result of higher floatation cost, the gap between the redemption value and the issue price is higher which results in higher the cost of preferred stock as well as higher WACC.

c) Increase in comoany's BETA - Increase in beta of the company results in the INCREASE IN WACC of the company because company use CAPM method to value the rate of return on equity and when CAPM increase WACC also increases.

The equation of the CAPM is

= Risk free rate of return(RF) + Risk premium i.e.(Market return - RF) * Beta

Since with the increase in beta rate of equity will be increases therefore WACC is also going to be increased as a result of increase in BETA of the company.

d) Increase in tax rate : Increase in tax rate results in lower rate of debt as well as preferred stock, therfore WACC is also going to be decreased.

e) Increase in market risk premium -  Increase in market risk premium of the company results in the INCREASE IN WACC of the company because company use CAPM method to value the rate of return on equity and when CAPM increase WACC also increases.

The equation of the CAPM is

= Risk free rate of return(RF) + Risk premium i.e.(Market return - RF) * Beta

Since with the increase in market risk premium, rate of equity will be increases therefore WACC is also going to be increased as a result of increase in market risk premium of the company.