Practice Question
Which of the following statements is true?
A) WACC cannot be used to evaluate projects in which the capital structure is much different from the firm’s overall structure.
B) WACC determines the cash flows that can be distributed to shareholders after paying operating costs, financing costs, and debt repayments.
C) WACC does not explicitly calculate interest tax shields that are generated by debt securities for the financing of a project.
D) WACC adjusts for the tax deductibility of interest costs.
E) All of the above.
Answer +
Final Answer: E) All of the above.
Explanation +
Explanation:
- A) True. WACC assumes a project’s capital structure mirrors the firm’s overall structure. If they differ significantly, WACC is not appropriate.
- B) True. WACC helps in calculating the residual cash flows available to shareholders after all costs, including financing costs, are paid.
- C) True. WACC incorporates tax shields indirectly via after-tax cost of debt but doesn’t explicitly isolate interest tax shields.
- D) True. WACC adjusts for interest tax deductibility using \( r_d (1 - T) \) where \( r_d \) is the cost of debt and \( T \) is the tax rate.
Conclusion: All statements are true. Hence, the correct answer is E) All of the above.