Chapter 10, Problem 1Q

Summary Introduction

To indicate: The affect of each of the scenario in cost of debt, cost of equity and WACC.

Introduction:

After-Tax Cost of Debt:

It can be defined as a relevant cost of the new debt considering tax deductibility in interest. It is the cost of debt after tax savings. The interest on the debt is tax deductible. The tax can saved on the interest paid on the debt. It is used to calculate the weighted average cost of capital

Cost of Equity:

It is the cost of the company while raising finance by issuing equity. It is earnings from the investment to the firm’s equity investors. It is the return to the stockholder holders’ equity investments. The issue of new stock incurs the flotation cost.

Weighted Average Cost of Capital:

It is the weighted average cost of capital of all the sources through which the firm finances its capital. It is a rate that the company will pay to all for raising finance. It can be termed as the firm’s cost of capital. The company raises money through various sources such as common stock and preference share debt. The WACC is calculated by taking the relative weight of each item of capital structure. The formula of WACC is:

$\text{WACC}={\text{W}}_{\text{d}}{\text{r}}_{\text{d}}\left(1-\text{t}\right)+{\text{W}}_{\text{P}}{\text{r}}_{\text{p}}+{\text{W}}_{\text{c}}{\text{r}}_{\text{s}}$

Where

• ${\text{W}}_{\text{d}}$ is the weight of the debt.
• ${\text{W}}_{\text{P}}$ is the weight of the preferred stock.
• ${\text{W}}_{\text{c}}$ is the weight of the equity.
• ${\text{r}}_{\text{d}}$ is cost of the debt.
• ${\text{r}}_{\text{P}}$ is cost of the preferred stock.
• ${\text{r}}_{\text{c}}$ is the cost of the equity.

Explanation of Solution

The table to show the effect of given events:

Scenarios	Effect on			Justification
	${\text{r}}_{\text{d}}\left(1-\text{T}\right)$	${\text{r}}_{\text{s}}$	WACC
a. The corporate tax is lowered.	+	0	+	The decrease in tax rate increases the cost of debt and hence it increases the WACC.
b. The federal reserve tightens credit	+	+	+	This scenario will positively affect cost of debt, cost of equity, and WACC.
c. The firm uses more debt; that is, it increases its debt ratio.	+	+	0	Increase in debt ratio somehow effect the cost of debt and cost of equity.
d. The dividend payout ratio is increased.	0	0	0	The increase in dividend payout ratio does not affect the cost of debt, cost of equity, and WACC.
e. The firm doubles the amount of capital it raises during the year.	0 or +	0 or +	0 or +	It may change or may not bring any change. Thus, there is equal chance.
f. The firm expands into a risky new area.	+	+	+	The raising of capital through risky project will have higher cost of capital than safer project.
g. The firm merges with another firm whose earnings are countercyclical both to those of the first firm and to the stock market.	-	-	-	This may negatively affect the cost of debt, cost of equity, and WACC.
h. The stock market falls drastically, and the firm’s stock price falls along with the rest.	0	+	+	The drastic fall in stock market does not affect the debt but increases both cost of debt and WACC.
i. Investors become more risk averse.	+	+	+	Risk affects the cost of debt, cost equity, and overall cost of the firm positively.
j. The firm is an electric utility with a large investment in nuclear power generation.	+	+	+	The large investment in nuclear power generation is risky. Risky investments raise cost of equity, cost of debt, and WACC.

Table (1)

Conclusion

Therefore, the affect of each scenarios on the firm’s debt, cost of equity and WACC has been indicated by a plus (+), a minus (-), or a zero (0).