Question

Which of the following statements about the cost of capital is CORRECT ? Select one:

a. Both the cost of debt and equity financing will decrease when a nuclear plant company encounters a ban on nuclear power generation in certain states.

b. Both the cost of debt and equity financing will decrease when a firm increases its debt/asset ratio.

c. Both the cost of debt and equity financing will decrease when a firm expands into a risky new area.

d. Both the cost of debt and equity financing will increase when the Federal Reserve tightens credit.

e. The WACC of a firm will decrease when investors become more risk averse.

Answer 1

Wacc is the weighted average cost of capital. Wacc = (%debt)*(cost of debt)*(1-tax) + (%equity)*(cost of equity)

a. False

When there is a ban on nuclear power generation, then it will get extremely difficult to raise money. Even if you get investors to invest then they will charge high rates. Thus both rates will increase to compensate for higher risk.

b. False. As debt keeps increasing , the risk increases as the firm has to keep paying interest. When debt increases cost of both debt and equity increases. Also when we increase debt chances are high that rating will downgrade.

c. False. When you enter into risky projects, the return required will increase and hence the rate for both debt and equity. Risk and return tradeoff is there.

d. True. When the Federal Reserve tightens credit then the amount of money available for giving out decreases. Thus, as availability decreases the price increases. And cost of both debt and equity increases.

e. False. When investors become risk averse then they demand higher return for every unit of risk. Thus, WACC will increase.