CFA® Level 1: CFA® Level 1

CFA® Level 1 Exam: Correct Statement

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Question

Which of the following statements is correct?

Answers

A. When the MCC (Marginal Cost of Capital) schedule is developed, the first break point always occurs as a result of using up retained earnings.

B. Flotation costs must be included in the component cost of preferred stock.

C. If a company with a debt ratio of 50 percent were suddenly exempted from all future income taxes, then, all other things held constant, this would cause its WACC to increase.

D. The WACC (Weighted Average Cost of Capital) should include only after-tax component costs. Therefore, the required rates of return on debt, preferred, and common equity must be adjusted to an after-tax basis before they are used in the WACC equation.

E. The cost of retained earnings is generally higher than the cost of new common stock.

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Explanations

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A. B. C. D. E.

If a firm paid no income taxes, its cost of debt would not be adjusted downward, hence the component cost of debt would be higher than if T (the firm's marginal tax rate) were greater than 0. With a higher component cost of debt, the WACC would be increased. Of course, the company would have higher earnings, and its cash flows from a given project would be high, so the higher WACC would not impede its investments, i.e., its capital budget would be larger than if it were taxed.

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