Question

Which of the following statements is CORRECT?

a. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.
b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.
c. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
d. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.
e. Higher flotation costs tend to reduce the cost of equity capital.

Answer 1

c. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.

Step-by-step explanation:

(A) and (B)

Financiation through debt provides a certain shield tax. The interest expense of the debt decrease the income tax expense. If those funds were from equity, the interest expense would not exist and the income tax expense will be higher.

Therefore, after-tax debt is lower than the pretax debt.

And referring to the relationship between the cost of debt and cost of equity, that is not set in stone, the rates change over time.

(D)the retained earnings are part of the capital, they will be expected to yield the cost of capital rate, not the cost of debt.

(E) the flotation cost increases the cost of equity capital

(C) The company must adjust his cost of capital for each project because there is a project which may be safer than others.

There is a trade-off between yields and risk, so each project should be evaluated with a rate according to his own risk.