Corp Finance - RFR & WACC

If central bank actions caused the risk-free rate to increase, what is the most likely change to cost of debt and equity capital?

A) Both increase. B) Both decrease. C) One increase and one decrease.

Your answer: C was incorrect. The correct answer was A) Both increase.

An increase in the risk-free rate will cause the cost of equity to increase. It would also cause the cost of debt to increase. In either case, the nominal cost of capital is the risk-free rate plus the appropriate premium for risk. I’m confused by this answer. Surely your cost of equity would decrease? Take an example: If RFR = 7% and we have the following CAPM. 7 + 1.4 (10-7) = 11.2 If RFR = 8% we get 8 + 1.4 (10-8) = 10.8 Surely the Kce has decreased as a result of an increase in rfr? How has an increase in RFR caused Cost of Debt to increase??

If the risk-free interest rate increases, it’s likely that the equity risk premium will increase as well. And not all equity has a beta greater than one.

Generally the cost of debt is the risk-free rate plus a spread; if the risk-free rate increases, the cost of debt will likewise increase.