Question

Which of the following statements is correct? An increase in the risk-free rate will increase the cost of debt. The WACC differs among a company's divisions depending on their riskiness. O All of the answers are correct OUsing internal capital is cheaper than using external capital due to flotation costs O A reasonable measure for the before tax cost of debt is the yield to maturity (adjusted for flotation cost) on outstanding debt.

Answer 1

Ans- Option C. All of the asnwers are correct.

- Increase in risk free rate will cause increase in cost of debt as market rate to raise funds will increase when the Fed Funds rate increases.

- Different company's division have different risk factor, and these risk factors will determine the cost at which the division can raise funds. Thus different divisions have differet WACC based on there risk factoers.

- Flotation cost decreases the share price the company will receive from external Capital funding source, Thus decreased price will increase the external cost of equity and since Internal source of funding (i.e., retained Earnings) does not have flotation cost.

Hence, Internal cost of equity is cheaper than external soyurce of equity.

- As WACC is computed usually based on market value of capital Budget, the before tax cost of debt to be taken for Market based WACC is the Yield to Maturity(adjusted to flotation cost if any). YTM is the market cost of debt that the investors are expecting.