Incorrect Statement About the Cost of Capital

D

A tax rate increase would lead to a decrease in the after-tax cost of debt and, consequently, the firm's WACC would decrease.

Let's analyze each statement and determine which one is incorrect:

A. The cost of retained earnings is equal to the return stockholders could earn on alternative investments of equal risk. This statement is correct. The cost of retained earnings is the opportunity cost of the funds retained by the company instead of being distributed to shareholders. It is equal to the return stockholders could earn on alternative investments of equal risk because if the funds were distributed, shareholders could invest them elsewhere to earn a similar return.

B. WACC calculations should be based on after-tax costs of capital. This statement is correct. The weighted average cost of capital (WACC) is a calculation that represents the average rate of return a company must generate to compensate all of its capital providers. Since interest on debt is tax-deductible, the cost of debt should be adjusted for taxes by using the after-tax cost of debt. Therefore, WACC calculations should be based on after-tax costs of capital.

C. Flotation costs can increase the WACC. This statement is correct. Flotation costs refer to the expenses incurred by a company when issuing new securities or raising capital. These costs include underwriting fees, legal fees, printing costs, and other expenses related to the issuance. Flotation costs increase the cost of capital, specifically the cost of equity. As a result, they can increase the weighted average cost of capital (WACC) since the WACC considers the cost of equity and the cost of debt.

D. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will increase. This statement is incorrect. The tax rate primarily affects the cost of debt and not the weighted average cost of capital (WACC) directly. An increase in the tax rate reduces the after-tax cost of debt since interest expenses become more tax-deductible. As a result, the cost of debt decreases, which in turn can lower the WACC if the company has a significant proportion of debt in its capital structure. Therefore, if the tax rate increases, all else equal, the WACC would generally decrease rather than increase.

E. A company's target capital structure affects its WACC (Weighted Average Cost of Capital). This statement is correct. The target capital structure refers to the mix of debt, equity, and other financing sources that a company intends to use to finance its operations. The WACC takes into account the cost of each component of capital and the respective weights in the capital structure. Therefore, a change in the target capital structure, such as increasing the proportion of debt, will affect the cost of capital, and consequently, the WACC will change. Higher proportions of cheaper sources of financing (such as debt) will generally result in a lower WACC, while higher proportions of more expensive sources of financing (such as equity) will lead to a higher WACC.

In summary, the incorrect statement is: D. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will increase.