question on cost of capital

CFA Level II
#1

Katherine Epler, a self-employed corporate finance consultant, is preparing a new seminar concerning debt ratings and how they impact capital structure policy. As she is working on her presentation, Epler prepares two presentation slides that contain the following: Slide 1: Lower debt ratings will increase the cost of debt as well as the cost of equity financing. Slide 2: Managers will always prefer to have the highest possible debt ratings. Is the information contained on Epler’s slides CORRECT? Information on slide 1 Information on slide 2 A) No No B) Yes Yes C) Yes No D) No Yes

#2

B. can’t see why managers would want a lower debt rating…

#3

D? could be wrong, but like cfasf, can’t see why a mgr wouldn’t want a higher debt rating. 1st one- does a lower debt rating up the cost of equity or just debt? i want to say it doesn’t mess with equity, just debt.

#4

cfasf1 Wrote: ------------------------------------------------------- > B. can’t see why managers would want a lower debt > rating… a company would have highest debt rating if it has no debt. Then as the company issues more debt its rating declines. optimal capital structure doesn’t have highest possible debt rating.

#5

very good point. optimal structure is where you can minimize the WACC. i think after studying all day i’m starting to lose my mind. how about the 1st part? does debt rating affect equity or no? i’m too tired right now to open the book. enlighten me.

#6

i would say d i dissagree that the highest debt rating would mean no debt at all as for the cost of debt it goes up with lower ratings which affects equity costs negatively as firm becomes more risky. what is the ans?

#7

ups got the ans wrong not d but C … having doubts though

#8

I was thinking C - if you wanted the highest debt rating you’d have no flexibility and the covenants on your bonds would dictate how you had to run the business (sufficient liquidity and all that crap). And lower debt ratings forces you to pay a higher interest rate, increasing the cost of debt, and if you use the bond yield yield + risk premium method to get a cost of equity, then your cost of equity will inrease too.

#9

cfasf1 got it right. the answer is B.