During a shareholder conference call, Miller states that the company’s objective is to minimize the weighted average cost of capital. She describes possible corporate actions. Use an amount equal to half of its net income to:
Corporate action 1
initiate a dividend
Corporate action 2
repurchase shares
Corporate action 3
reduce existing debt
Given its objective and the three possible corporate actions, Skylark is least likely to select:
- Corporate action 1.
- Corporate action 2.
- Corporate action 3.
Answer is c. My answer was b. why does repurchases and dividends decrease wacc? My logic was as follows. when you pay a dividend your stock price is lowered which reduces the risk premium in your capm equation. this means cost of equity goes down. for repurchases market value of equity remains unchanged but b/c price of stock goes up your risk premium goes up which increases cost of equity. (Repurchases and dividends should have the same effect on wacc but I cant properly explain why). can someone please help.
I think the reason goes back to the effect capital structure has on cost of equity, cost of debt, and WACC. First, let’s break down the changes in capital structure from each corporate action:
Both a stock repurchase and dividend would:
-reduce the company’s cash, reducing equity
-increase D/E as debt remains unchanged
Reducing existing debt with would:
-reduce both debt and cash
-decrease D/E as equity remains unchanged
Since cost of equity is typically much higher than debt, paying off debt with cash will result in a capital structure with a heavier weight in equity, thus increasing WACC. Stock repurchase and dividend would have the opposite effect on the firm’s capital structure and WACC.
The caveat is that as a company uses more leverage, the cost of equity and cost of debt will gradually increase due to investors requiring a higher return for the added risk.
i see. well that makes sense. the lower the weightage on debt the higher the weightage on equity. given that equity has a higher required return thats going to push up wacc. vice versa when you increase debt and decrease equity. lowers wacc. ok i think i get that. thanks very much take08!