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A company is going to take on a project using a mixture of debt and equity 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 finance used for 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 ?
:/
for some odd reason the Beta keeps changing to ? when ever i submit the postI don’t know where you found this question, but it is a rather silly question 🙂
First of all the equity beta is always bigger than the asset beta, if there is gearing. The only reason the betas are different is because the existence of gearing makes the equity more risky (and therefore a higher beta). Answers B and D are therefore immediately impossible.
Second, calculating a cost of equity using the asset beta would give the cost assuming no gearing and would therefore be equal to the WACC if there were no gearing. According to M&M the WACC of a geared company will always be lower than the WACC of an ungeared company. Both A and C are still possible on this one.
Finally, we always calculate the cost of equity using the equity beta. The WACC is the average of this cost of equity and the cost of debt (and cost of debt is always lower than cost of equity). Therefor WACC is lower than cost of equity using the equity beta.
Therefore (finally) the answer is A.
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