Question

True or false and why?

1. Other things held constant, a decrease in a firm’s marginal tax rate would lower the cost of debt when calculate its WACC.

2. The component costs of capital are market-determined variables in the sense that they are based on investors’ expected returns.

Answer 1

1. False

Cost of debt is denoted as = k_d(1-t) , if the tax rate decreases that cost of debt will increase. Debt serves as tax saving for firm hence it is more preferable to equity.

When cost of debt will increase the WACC will also increase as it is weighted average of cost of debt and cost of equity.

2.True

Component cost of capital is the actual cost of debt or cost of equity which are required by the investors. Investors expect that if they loan a certain amount of money they get a certain return on their money, this is also same with equity if investors invest in the capital of a company they expect a certain return percentage which is further based on their risk profile.