Cost of Capital Effects

Cost of Capital Effects: Indicate the probable effect on the cost of equity i.e. the return required by shareholders of the company, of the following scenarios. If it is going to increase, use “+”, for decrease use “-“ and if no change is expected use “0”.

Update:

(a)Corporate tax rate is lowered

(b)Firm expands into a risky area

(c)Firm merges with another firm whose earnings are counter-cyclical to both those of the firm and the overall market

Update 2:

please give short explainations, tks

1 Answer

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  • Jim
    Lv 6
    1 decade ago
    Favorite Answer

    a)Corporate tax rate is lowered

    (a) +

    Corporate tax rate is lowered which translate to higher profit for business. As investors realize that businesses are able to retain higher profit, the investors would ask for higher return on their captial investments. Which means a higher cost of captial for businesses. (+)

    (b)Firm expands into a risky area

    (b) +

    As a firm is seen as more risky, the investors would ask for higher return on their captial investments. Which means a higher cost of captial for businesses. (+) The same goes for bond rating. AAA - the least risky always have the lowest rate of return, junk bond - C and below always required to have the highest rate of return.

    (c)Firm merges with another firm whose earnings are counter-cyclical to both those of the firm and the overall market

    (c) -

    A firm merges with another that offset their earning potential will affect the company to be seem as less risky. More likely this firm will result with a more steady profit potential year round, which means that the risky is reduced. Opposite of question a & b, the cost of captial will reduce. (-)

    Source(s): My study
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