Which of the following statements is CORRECT? A) In the WACC calculation,we must adjust the cost of preferred stock (the market yield)to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income. B) We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes. C) The cost of new equity (r_e)could possibly be lower than the cost of retained earnings (r_s)if the market risk premium,risk-free rate,and the company's beta all decline by a sufficiently large amount. D) Its cost of retained earnings is the rate of return stockholders require on a firm's common stock. E) The component cost of preferred stock is expressed as r_p(1 - T),because preferred stock dividends are treated as fixed charges,similar to the treatment of interest on debt.

Question

Quizplus · Accepted Answer

The statement in option D is correct. The cost of retained earnings is the rate of return required by common stockholders to forego consumption today and invest in a company's common stock, taking into account the perceived level of risk associated with the investment. Option A is incorrect as the tax adjustment for preferred stock is made to reflect that corporations receiving the dividends are allowed to deduct 70% of the dividend income received from their taxable income. Option B is also incorrect as historical measures may not reflect the current market conditions or the company's current risk profile, and new estimates may be required. Option C is incorrect as it is highly unlikely for all three variables to decline simultaneously to result in a lower cost of new equity. Option E is incorrect as the preferred dividends are not tax-deductible, and as such, the tax adjustment is made to derive the after-tax cost of preferred stock.

Which of the Following Statements Is CORRECT