Company A’s current capital structure is 50% equity at an average cost of 10% and 50% debt at an average aftertax cost of 3%, assuming a 40% tax rate.
Company B has totally financed its operations with equity at an average cost of 7% and has a tax rate of 40%.
If both companies issue debt at pay with a 7% coupon rate, what will be the effect on each company’s MCC (Marginal Cost of Capital?)
A) Only Company A will have a lower MCC
B) Only Company B will have a lower MCC
C) Both companies will have a lower MCC.
The answer key states B, because for Company A, the after tax cost of debt is higher than their current cost of debt. I disagree. I say it is C because the after tax cost of debt (4.2%) is currently lower than their current WACC (6.5%)
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