chalheim Sisters Inc. has always paid out all of its earnings as dividends, henc
ID: 2755012 • Letter: C
Question
chalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?
The market risk premium increases.
The flotation costs associated with issuing new common stock decrease.
The company’s beta increases.
Expected inflation increases.
The flotation costs associated with issuing preferred stock increase.
Explanation / Answer
The correct answer is - When The flotation costs associated with issuing new common stock decrease.
Floatation cost is the cost associated with issuing securities such as underwriting, legal, listing and printing fees. Hence as this cost reduces the weighted average cost of capital (WACC) also reduces.
As per CAPM, the cost of equity for Chalheim Sisters Inc can be calculated using following formula:
R = Rf + b (Rm -Rf), where R = Required rate of return on equity, Rf= Risk free return & Rm -Rf =Market Risk premium, b = Beta
From above equation we can see that the WACC of the company would reduce in case of following events-
The market risk premium decreases.
Company's beta decreases.
Expected inflation decrease, as expected reduction in inflation would also reduce the market risk premium.
Hence all other events provided are ruled out.
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