Question

Which of the following statements is CORRECT? (Note: a thought-provoking conceptual question!) a. When calculating the cost of preferred stock,

a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.
b. All else equal, an increase in a company's stock price will increase its marginal cost of retained earnings, rs.(hint: think of the DCF approach: Equation 9-9)
c. All else equal, an increase in a company's stock price will increase its marginal cost of new common equity,
d. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt.
e. If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.

Answer 1

Among the given options, the correct statement is that all else equal, an increase in a company's stock price will increase its marginal cost of new common equity. The cost of retained earnings is not directly affected by changes in stock price and preferred stock dividends are not tax deductible.

Step-by-step explanation:

The correct statement among the options provided is: All else equal, an increase in a company's stock price will increase its marginal cost of new common equity. This is because when using the Discounted Cash Flow (DCF) approach to calculate the cost of equity (Equation 9-9), an increase in stock price leads to a higher cost of new common equity. Preferred dividends are not tax deductible, contrary to what option a suggests. Therefore, preferred stock dividends are not adjusted for taxes like interest expenses on debt. The cost of retained earnings (rs) doesn't directly depend on the stock price because retained earnings involve money already in the company and not new capital. For option d, the after-tax cost of retained earnings is usually lower because there are no direct costs associated with raising new funds. Lastly, for option e, the after-tax cost of debt actually increases if the company's tax rate increases and the yield to maturity (YTM) on its noncallable bonds remains the same, as the tax shield value of the debt interest is reduced.