Which one of the following statements is correct, all things being equal?

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BlackTom AI · Accepted Answer

The question asks us to identify which statement is correct when all else is equal. 
Option 1: 'The after-tax cost of debt increases when the market price of a bond increases.' This is incorrect in standard capital structure theory. When bond prices rise, yields fall, which lowers the after-tax cost of debt (since cost of debt is tax-deductible and tied to yield). So the statement as written contradicts the inverse relationship between price and yield. 
Option 2: 'Beta is used to compute the return on equity and the standard deviation is used to compute the return on preference shares.' This mixes concepts. Beta is a measure used in CAPM to estimate the cost of equity, not directly the return on equity in isolation; standard deviation is a risk measure, not typically used to compute returns on preference shares, which are usually fixed-coupon and valued differently. As stated, this pairing is muddled and inaccurate. 
Option 3: 'WACC is only applicable to firms that issue both common ordinary and preference shares.' This is false. WACC can be applied to any firm with a weighted cost of capital that reflects its sources of financing (debt, equity, etc.), regardless of whether it has preference shares. Many firms issue only debt and common equity and still compute WACC. 
Option 4: 'If you have both the dividend growth and the security market line's costs of equity, you should use the higher of the two estimates when computing WACC.' This is not standard practice. In practice, you choose a single cost of equity estimate consistent with your valuation framework (e.g., CAPM-based cost from the SML or dividend discount/growth model) and avoid arbitrarily taking the higher of two different models, which would bias the WACC upward. 
Option 5: 'A decrease in a firm's WACC will increase the attractiveness of the firm's investment options.' This statement aligns with fundamental capital budgeting logic. A lower WACC reduces the hurdle rate, meaning more projects will have positive net present values, making investments more attractive relative to the previous higher discount rate. It reflects the idea that cheaper capital broadens the set of opportunities that meet the required return threshold. 
Thus, when comparing all options, the statement in Option 5 correctly captures the effect of a lower WACC on investment attractiveness, while the others contain common misconceptions about debt pricing, cost of equity estimation, WACC applicability, and model usage.

BFIN011 Week 9: Practice Quiz- Requires Respondus LockDown Browser

Which one of the following statements is correct, all things being equal?

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