Question

Black River Tours has a capital structure of 55 percent common stock, 5 percent preferred stock, and 40percent debt. The firm has a 30 percent dividend payout ratio, a beta of 1.21, and a tax rate of 34 percent. Given this, which one of the following statements is correct?

A. The after tax cost of debt will be greater than the current yield-to-maturity on the firm's outstanding bonds.
B. The firm's cost of preferred is most likely less than the firm's actual cost of debt.
C. The firm's cost of equity is unaffected by a change in the firm's tax rate.
D. The cost of equity can only be estimated using the capital asset pricing model.
E. The firm's weighted average cost of capital will remain constant as long as the firm’s capital structure remains constant.

Answer 1

Option C) The firm's cost of equity is unaffected by a change in the firm's tax rate.

Step-by-step explanation:

To calculate the firm's Cost of Equity we can use the CAPM Model which indicates the following:

ER: Rf + Bi (Erm + Rf)

ER: (Expected Return)

Rf: (Risk Free)

Bi: (Beta)

Erm: (Expected Return on Market)

In this way we can calculate the cost of equity only considering the Risk Free Rate and the Market Risk Premium (Erm + Rf), in this case we don't need the tax rate to calculate our cost of equity which yes it's neccesary in the use of WACC Model.