Question

Which of the following statements is CORRECT? When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM. If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock. Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC.

Answer 1

When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation

Step-by-step explanation:

A debt on which the company pays interest, will be tax deductible.

The reason is that the interest are treated as expense thus, reducing the taxable income. While the dividends to preferred or common stock don't.

The formula for after-tax cost of debt:

pre-tax cost ( 1 - tax-rate ) = after-tax

example, if a bon pays 10% and the tax rate is 25%

0.10 ( 1- 0.25) = 0.10 x 0.75 = 0.075 = 7.5%

The real cost of debt is 7.5 because, the tax shield offered from the interest.