CFA Practice Question

CFA Practice Question

Which of the following factors affect a firm's cost of capital?

I. Tax rates
II. Investment Policy
III. Dividend Policy
IV. The level of interest rates
V. Capital Structure Policy
A. I, II, III, IV and V.
B. II, III, IV and V.
C. I, III and IV.
Explanation: Each of these factors may affect a firm's cost of capital. As interest rates rise, the cost of debt will also rise forcing firms to pay a higher rate of interest on debt capital (bonds). Tax rates also affect the cost of debt. Furthermore, a lower capital gains tax rate relative to ordinary income tax rates will affect the cost of equity capital relative to the cost of debt capital. Capital structure policy will affect the weighted average cost of capital (WACC), as well as affect the riskiness of both equity and debt capital. A change in the level of capital risk will in turn also affect the WACC. Dividend policy including the level of dividends and stability of dividends will have a direct affect on the cost of equity capital. Finally, a firm's WACC is affected by its investment policy. The types of investments that a firm undertakes and the riskiness of those investments are reflected in the WACC.

User Contributed Comments 1

User Comment
harrybay Not sure about the dividend policy though. What happened to Modigliani and Miller's WACC being independant of dividends?
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