Which of the following statements is CORRECT?
A) When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
B) Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
C) If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough reinvested earnings to take care of its equity financing and hence must issue new stock.
D) Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC.
E) When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

Question

Quizplus · Accepted Answer

Interest payments on debt are tax deductible, so companies must adjust for taxes when calculating the after-tax cost of debt. Choices A and B are incorrect because dividends paid on preferred stock are not tax deductible, and an increase in the risk-free rate affects the cost of debt and common stock similarly in the CAPM. Choice C is incorrect because an increase in beta would increase the cost of equity financing regardless of whether the company has sufficient reinvested earnings. Choice D is incorrect because flotation costs, which are the costs associated with issuing new securities, do not affect investors' expected returns and therefore do not impact a company's WACC.

Which of the Following Statements Is CORRECT