Smith Company has no retained earnings. The company uses the CAPM to calculate the cost of equity capital. The company's capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce the company's WACC?
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A. B. C. D. E.Explanation
If the risk premium decreases, the required return on common equity will be reduced. All of the other answers will increase the firm's WACC.
To determine which event will reduce the company's weighted average cost of capital (WACC), let's analyze each answer choice and its impact on WACC:
A. An increase in the flotation costs associated with issuing preferred stock: Flotation costs are the expenses incurred when a company issues new securities. If the flotation costs associated with issuing preferred stock increase, it will raise the cost of obtaining capital through preferred stock. This increased cost will result in a higher cost of equity and, subsequently, a higher WACC. Therefore, this event will not reduce the company's WACC.
B. An increase in the flotation costs associated with issuing common equity: Similar to the previous choice, an increase in the flotation costs associated with issuing common equity will also lead to a higher cost of equity. As a result, the WACC will increase rather than decrease.
C. A reduction in the market risk premium: The market risk premium is the additional return an investor expects to earn for investing in a risky asset over the risk-free rate of return. When the market risk premium decreases, the cost of equity capital decreases as well. Since the WACC is a weighted average of the costs of different sources of capital, a decrease in the cost of equity will lower the overall WACC. Therefore, this event will reduce the company's WACC.
D. An increase in the company's beta: The beta is a measure of a stock's sensitivity to market movements. An increase in the company's beta implies that the stock's volatility relative to the market has increased. Since the cost of equity is directly related to beta in the CAPM model, an increase in beta will raise the cost of equity. Consequently, the WACC will increase rather than decrease.
E. An increase in expected inflation: Expected inflation affects the cost of debt, which is one component of the company's capital structure. If inflation increases, lenders will demand higher interest rates to compensate for the erosion of purchasing power over time. As a result, the cost of debt will rise, leading to an increased WACC.
Based on the analysis, the only event that will reduce the company's WACC is choice C: a reduction in the market risk premium.