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 company’s beta increases.

c. the flotation costs associated with issuing new common stock increase.

d. expected inflation increases.

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

Correct option is (a)

Explanation:

Market risk premium refers to difference between market return and risk free rate. It establishes a relationship between market return on portfolio and return on government bonds (relationship between risky and risk free securities).

It is used in calculating cost of equity using capital asset pricing model. in order to reduce WACC, cost of equity should also fall. Formula to calculate cost of equity using CAPM is as follows:

Ke = Rf + β(Rm - Rf)

where,

Ke is cost of equity

Rf is risk free rate

Rm is market return

Rm - Rf represents market risk premium (Rp)

If Rp declines cost of equity will fall (as can be seen from the formula), thereby decreasing WACC.

If Beta increases, cost of equity will also increase.

Flotation cost is cost incurred in making securities available to public. Again, increase in flotation cost and inflation will increase WACC as associated cost of financial tool increases.

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