Which of the following statements is true? Please explain. •If Congress raised t

Question

Which of the following statements is true? Please explain.

•If Congress raised the corporate tax rate, this would lower the effective cost of debt.

•If Congress raised the personal income tax rate, investors would demand more corporate debt financing, and companies’ debt ratios would increase.

•The calculation for a firm’s WACC includes an adjustment to the cost of debt for taxes, since interest is deductible, and includes the cost of all current liabilities.

•Since the money is readily available, the cost of retained earnings is usually a lot cheaper than the cost of debt financing.

Explanation / Answer

•If Congress raised the corporate tax rate, this would lower the effective cost of debt. As there is (1-tax rate) multiplication to the cost of debt, cost of debt will be lowered with the increase in tax rate

Why other statements are incorrect

•If Congress raised the personal income tax rate, investors would demand more corporate debt financing, and companies’ debt ratios would increase. If personal income tax rate increases, corporate financing would not be impacted

•The calculation for a firm’s WACC includes an adjustment to the cost of debt for taxes, since interest is deductible, and includes the cost of all current liabilities. It does not include the cost of current liabiites it inlcudes only the long term portion of liabilities

•Since the money is readily available, the cost of retained earnings is usually a lot cheaper than the cost of debt financing. Cost of Retained earnings is higher than the cost of debt because the current stock price implies the cost of retained earnings and investors demand higher return in equity than debt

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