Question

Which of the following statements is/are true? Multiple Choice A. All else held constant, if a company has a beta of 1.2, then the cost of equity for this company will increase if the risk-free rate decreases. B. If you assume a company has debt, then an increase in the tax rate will decrease the weighted average cost of capital for the company. Both A and B are true. Neither A nor B are true.

Answer 1

Answer:

Both A and B are true.

• A. All else held constant, if a company has a beta of 1.2, then the cost of equity for this company will increase if the risk-free rate decreases.
• B. If you assume a company has debt, then an increase in the tax rate will decrease the weighted average cost of capital for the company.

Explanation:

A)

The formula to calculate the cost of equity is:

cost of equity = risk free rate of return + [Beta × (market rate of return – risk free rate of return)]

e.g. market rate 15%, risk free rate 5%:

cost of equity = 5% + [1.2 x (15% - 5%)] = 5% + 12% = 17%

if the risk free rate decreases to 3%:

cost of equity = 3% + [1.2 x (15% - 3%)] = 3% + 14.4% = 17.4%

B)

the WACC formula = (cost of equity x weight of equity) + [cost of debt x weight of debt x (1- tax rate)]

if the tax rate increases, then the WACC will decrease because (1 - tax rate) will be lower.