[Corporate Finance] WACC

[pivpomars]

Question 78 - #97744 [removed by admin] -------------------------------- In my opinion, A can’t be a good answer because: if the beta is negative, a reduction of Market risk premium will increases the cost of equity, so increases the WACC ( k_e = RFR + beta * MarketRiskPremium ). Am I right? Thanks in advance for your help!

[S2000magician]

@pivpomars

Question 78 - #97744

Which of the following events will reduce a company’s weighted average cost of capital (WACC)?

A) A reduction in the market risk premium.

B) An increase in expected inflation.

C) A reduction in the company’s bond rating.

The answers is A.

An increase in either the company’s beta or the market risk premium will cause the WACC to increase using the CAPM

approach. A reduction in the market risk premium will reduce the cost of equity for WACC.

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In my opinion, A can’t be a good answer because: if the beta is negative, a reduction of Market risk premium will increases the cost of equity, so increases the WACC (k_e = RFR + beta * MarketRiskPremium). Am I right?

You are. However, I would defy you to find more than a handful of companies whose betas are negative; you might not find any. (The returns for such a company’s stock would have to have a negative correlation with the returns of the market; that’s incredibly rare for any extended period of time.) It appears that CFA Institute assumes that beta is positive. Given that, the answer is correct.

@pivpomars

Thanks in advance for your help!

You’re welcome.

[pivpomars]

Thanks for your answer.

After a quick look in Internet, I found that beta can be negative if the asset class is the gold which usuallly goes agains the equity markets. It seems to me that it is the unique asset having negative beta.

[busprof]

Although some stocks have exhibited betas for a short period, this is usually a statistical artifact occurring because of some unusual event (usually idiosyncratic, like a lawsuit or other event risk). nd this happens in VERY rare cases (I could probably run 2-year rlling betas of all stocks listed in the CRSP dataset (used by academics everywhere for this stuff) for the last 50 years for 6-8000 stocks and find (maybe) a hundred cases in that sample.

While we often estimate betas using past data, the key is that the beta we need is a forward looking one, since it’s being used to estimate future costs. Making a case for a negative beta in a forward lloking case would be pretty tough. So, I think it’s reasonable for CFA institute (and everyone else) to assume that betas are positive.

[S2000magician]

@pivpomars

Thanks for your answer.

You’re welcome.

@pivpomars

After a quick look in Internet, I found that beta can be negative if the asset class is the gold which usuallly goes agains the equity markets. It seems to me that it is the unique asset having negative beta.

I confined my reply to stocks, not bonds, not commodities, not real estate, not anything else. Yes, there are some assets whose betas can be negative for long periods of time. I wouldn’t use CAPM to estimate the required rate of return for such an asset.

[edupristine]

In general beta is always positive and by assuming this we can say option A is correct.

And if in case the beta is negative the question will provide you a hint to decrease a WAAC is,

• A increase in the market risk premium.

[hellind]

Most questions qualify with ‘most likely’ or ‘least likely’

I am surpised this question does not.