Choose the Most Correct answer for relative costs of components of a firm\'s cap
ID: 2635761 • Letter: C
Question
Choose the Most Correct answer for relative costs of components of a firm's capital structure. Where: RS = Rate investors demand on a firm's STOCK RD = Rate investors demand on a firm's DEBT (i.e., the Yield to Maturity of the firm's debt). WACC = The firm's Weighted Average Cost of Capital t = the firm's tax rate. "<" means "Less Than" ">" means "Greater Than or equal to"
a) RS > RD > WACC
b) WACC > RS > RD
c) RS > RD > RD(1-t)
d) RS < RD(1-t) < RD
e) None of these relationships is correct.
Explanation / Answer
Ans: c) RS > RD > RD(1-t)
Reason: In case of bond , the enterprise is commited to pay the annual interest to the investors and hence generally investors expected lower rate in bonds compared to stocks where there is no commited annual payment. Stock investments are speculative in nature , that is high risk high return type of investment. The cost of capital of an enterprize further reduces in bond as the interest is tax deductible.