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Question:
Over the next year, Thatherton Co. is expecting their marginal tax rate to increase by 5%. Also, over the next 12 months, Thatherton plans to undertake several expansion projects significantly more risky than previous projects. Thatherton Co.'s current capital structure includes 40% debt and 60% equity. Which of the following statements correctly summarizes the effect these changes will have on the company's marginal cost of capital?
A
The riskier projects will increase the MCC.
explanation
Recall that the marginal cost of capital (MCC) is the cost of the last dollar of new capital raised by the firm. Marginal cost increases as increasing amounts of capital are raised during a set period. In general, firms in riskier businesses, or with riskier projects, have higher costs of common equity and thus higher MCC and WACC. The increase in the tax rate would reduce the after-tax cost of debt, reducing the MCC.
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