The weighted average cost of capital for a wholesaler:
a. is equivalent to the after tax cost of the firm's liabilities.
b. should be used as the required return when analyzing a potential acquisition of a retail outlet.
c. is the return investors require on the total assets of the firm.
d. remains constant when the debt-equity ratio changes.
e. is unaffected by changes in corporate tax rates.
Capital structure refers to the mix of equity and debt used to finance a company's operation. A company should strive to create an optimal capital structure. Optimal capital structure is created by finding the point where the use of both equity and debts lowers the cost of capital and maximizes company value.
Answer and Explanation:
The correct answer is C
The weighted average cost of capital represents the average return paid to investors who finance company assets. It is the discounting rate used in determining the present value of all future income.
The other choices are wrong because.
A). Is equivalent to the after-tax cost of the firm's liabilities.
- The weighted average cost of capital (WACC) represents the average cost of capital a firm pays for using different sources of financing. WACC is not equivalent to the after-tax cost of a firm?s liabilities because all sources of financing costs are included in the calculation of WACC.
B). Should be used as the required return when analyzing a potential acquisition of a retail outlet.
- The weighted average cost of capital (WACC) of the company being acquired should be used in analyzing the value of the firm. Retail outlet WACC should be used evaluating its value and not the wholesale WACC.
D). Remains constant when the debt-equity ratio changes.
- Weighted average cost of capital (WACC) is dependent on capital structure, therefore a change in capital structure changes the WACC.
E). Is unaffected by changes in corporate tax rates.
- Change in corporate tax affects the after-tax cost of debt. The after-tax cost of debt is used when calculating the weighted average cost of capital, hence a change in the after-tax cost of debt will change WACC.
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from Finance 101: Principles of FinanceChapter 15 / Lesson 1