10-1    How would each of the following scenarios affect a firm’s cost of debt, rd(1 - T); its cost of equity, rs; and its WACC? Indicate with a plus (+), a minus (-), or a zero (0) if the factor would raise, would lower, or would have an indeterminate effect on the item in question. Assume for each answer that other things are held constant even though in some instances this would probably not be true. Be prepared to justify your answer but recognize that several of the parts have no single correct answer. These questions are designed to stimu- late thought and discussion.

 

 

 

 

 

 

EFFECT ON

 

rd(1 - T)                rs                                   WACC

a.  The corporate tax rate is lowered.                       

                                                     

b.  The Federal Reserve tightens credit.                    

                                                     

c.  The firm uses more debt; that is, it increases its debt/assets ratio.

d.  The dividend payout ratio is increased.               

                                                     

e.  The firm doubles the amount of capital it raises during the year.

f.  The firm expands into a risky new area.               

                                                     

g.  The firm merges with another firm whose earnings are countercyclical both to those of the first firm and to the stock market.

h.  The stock market falls drastically, and the firm’s stock price falls along with the rest of the stocks.

i.  Investors become more risk-averse.                     

                                                     

j.  The firm is an electric utility with a large investment in nuclear plants. Several states are considering a ban on nuclear power generation.