At a recent Haggerty Semiconductors Board of Directors meeting, Merle Haggerty was asked to discuss the topic of the company’s weighted average cost of capital (WACC).
At the meeting Haggerty made the following statements about the company’s WACC:
Statement 1: A company creates value by producing a higher return on its assets than the cost of financing those assets. As such, the WACC is the cost of financing a firm’s assets and can be viewed as the firm’s opportunity cost of financing its assets.
Statement 2: Since a firm’s WACC reflects the average risk of the projects that make up the firm, it is not appropriate for evaluating all new projects. It should be adjusted upward for projects with greater-than-average risk and downward for projects with less-than-average risk.
Are Statement 1 and Statement 2, as made by Haggerty CORRECT?
| Statement 1 | Statement 2 |
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Each statement that Haggerty has made to the board of directors regarding the weighted average cost of capital is correct. New projects should have a return that is higher than the cost to finance those projects.
Which of the following choices best describes the role of taxes on the after-tax cost of capital in the U.S. from the different capital sources?
| Common equity | Preferred equity | Debt |
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In the U.S., interest paid on corporate debt is tax deductible, so the after-tax cost of debt capital is less than the before-tax cost of debt capital. Dividend payments are not tax deductible, so taxes do not decrease the cost of common or preferred equity.
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