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Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?

a. The market risk premium declines.

b. The flotation costs associated with issuing new common stock increase.

c. The company?s beta increases.

d. Expected inflation increases.

e. The flotation costs associated with issuing preferred stock increase.

Respuesta :

jepessoa

Answer:

A) The market risk premium declines.

Explanation:

The market risk premium is used in the CAPM model to determine the cost of equity (which is part of the WACC):

Ke = Rf + β(Rm - Rf)

  • Ke = cost of equity
  • Rf = risk free rate
  • Rm = market return
  • Rm - Rf = market return - risk free rate = market risk premium (Rp)

If the market risk premium decreases (Rp), then the cost of equity (Ke) will decrease, which will decrease the WACC.

hyderali230

Answer:

a. The market risk premium declines.

Explanation:

As we know Market risk premium is used to calculate the cost of equity, which is used in WACC calculation. The reduction in market risk premium will decrease the cost of equity and ultimately the WACC.

Example

Using CAPM formula

Cost of Equity = Rf + β ( market risk premium )

Placing assumed values in the formula

Cost of Equity = 4% + 1.2 ( 6.4% ) = 11.68%

WACC = (11.68% x 60%) + (5.6% x 40%) = 9.25%

After reduction

Keeping all other values constant and reducing Market risk premium to 5.8%

Cost of Equity = 4% + 1.2 ( 5.8% ) = 10.96%

WACC = (10.96% x 60%) + (5.6% x 40%) = 8.82%

Hence proved that the decline in market risk premium will reduce the WACC.