Question

Agency has a capital structure of 60 percent common stock, 5 percent preferred stock, and 35 percent debt. The dividend payout ratio is 30 percent, the company's beta is 1.21, and the tax rate is 21 percent. Given this, which one of the following statements is correct?

a. The aftertax cost of debt will be greater than the current yield-to-maturity on the company's outstanding bonds.
b. The company's cost of preferred is most likely less than the company's actual cost of debt.
c. The cost of equity is unaffected by a change in the company's tax rate.
d. The cost of equity can only be estimated using the capital asset pricing model.
e. The weighted average cost of capital will remain constant as long as the company's capital structure remains constant.

Answer 1

Answer: c. The cost of equity is unaffected by a change in the company's tax rate.

Step-by-step explanation:

The cost of debt can be adjusted for taxes because interest payments are tax deductible. This is not the case with Equity. Equity is not tax deductible so there is not adjustment to the cost of Equity for taxes.

This means therefore, that the calculation of cost of equity will not change in any way due to the company's tax rate. For this reason, the cost of equity is usually higher than that of debt.