Question

Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity.a. The WACC is calculated on a before-tax basis.b. The WACC exceeds the cost of equity.c. The cost of equity is always equal to or greater than the cost of debt.d. The cost of reinvested earnings typically exceeds the cost of new common stock.e. The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.

Answer 1

The correct statement among the given is 'cost of equity is always equal to or greater than the cost of debt' .

Option-c

Explanation:

Debt on assets which are less likely to lose is secured more uncertainty leads to lower returns, hence lower costs. The risk of loss to equity holders also remains greater and not even assured against any collateral. In comparison to higher risk equity holders foresee higher returns.

This is why debt costs are higher. Such high risk will lead to higher equity costs than debt costs. To investors, equity costs would be returned on equity investment, and debt costs would be made as part of debt investment.