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Hello Sir, .
Ques – A company is going to take on a project using a mix of equity and debt finance in an
economy where the corporation tax rate is 30%.
Assuming perfect markets, other than tax, which of the following statements is true
about the project?
A ?e > ?a; WACC < Cost of equity calculated using ?a; WACC < Cost of equity calculated
using ?e
B ?e < ?a; WACC > Cost of equity calculated using ?a; WACC > Cost of equity calculated
using ?e
C ?e > ?a; WACC < Cost of equity calculated using ?a; WACC > Cost of equity calculated
using ?e
D ?e < ?a; WACC > Cost of equity calculated using ?a; WACC < Cost of equity calculated
using ?eAnswer is A , I understand that Be>Ba but the rest part is bit unclear for me.
If the company was entirely equity financed then the WACC would be equal to the cost of equity and would be given by the asset beta.
According to Modigliani and Miller, when there is tax then a geared company will have a lower WACC than an ungeared company. Therefore the WACC will be less that the cost of equity calculated using the asset beta.
Since the cost of equity using the equity beta will be higher than the cost of equity using the asset beta, the WACC must be lower than the cost of equity using the equity beta.
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