Which of the following statements is most correct?
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A. B. C. D. E.A
Obviously if the firm is paying no taxes, its after-tax cost of debt will equal its before-tax cost of debt.
Let's go through each statement and evaluate its correctness:
A. Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few years whether or not the firm uses debt financing. Thus the firm's after-tax cost of debt will equal its before-tax cost of debt.
This statement is false. The cost of debt is typically lower after considering the tax shield from interest expense deductions. When a firm has debt financing, it can deduct interest payments from its taxable income, reducing the taxes it owes. If a firm is not paying taxes because it is incurring losses, the tax shield from interest deductions would have no value. Therefore, the after-tax cost of debt would be equal to the before-tax cost of debt in this scenario.
B. The bond-yield-plus-risk-premium approach to estimating a firm's cost of common equity involves adding a subjectively determined risk-premium to the market risk-free bond rate.
This statement is false. The bond-yield-plus-risk-premium approach is used to estimate the cost of debt, not the cost of common equity. The cost of common equity is typically estimated using the capital asset pricing model (CAPM), which incorporates the risk-free rate of return, the beta of the stock, and the market risk premium. It does not involve adding a risk premium to the market risk-free bond rate.
C. The reason that a cost of capital is assigned to retained earnings is because these funds are already earning a return in the business, the reason does not involve the opportunity cost principle.
This statement is false. The cost of capital is not assigned to retained earnings. Retained earnings represent the internally generated funds of a company, and they do not have an explicit cost associated with them. The cost of capital is the required rate of return on a company's investments, and it is used to evaluate the attractiveness of investment opportunities. When evaluating projects, the cost of capital is used to determine the minimum rate of return that the project should generate to be considered acceptable. It involves the opportunity cost principle because the cost of capital represents the return that could be earned by investing in alternative projects with similar risks.
D. The component cost of preferred stock is expressed as k(ps)(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.
This statement is true. The cost of preferred stock is expressed as k(ps)(1 - T), where k(ps) represents the required rate of return on preferred stock and (1 - T) represents the tax shield. Preferred stock is a hybrid security that combines features of both equity and debt. Like debt, preferred stock pays fixed dividends, which are considered fixed charges. However, preferred stock dividends are not tax-deductible, so the tax shield factor is applied.
E. All of these statements are false.
This statement is false. Statement D is correct, so not all of the statements are false.
In conclusion, the correct answer is D. The component cost of preferred stock is expressed as k(ps)(1 - T) because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.