Reducing its operating leverage would not cause the firm's cost of capital to increase. Reducing its operating leverage would decrease the firm’s cost of capital, because it would decrease the amount of risk that investors would perceive in the company.
Reducing its operating leverage would not cause the firm's cost of capital to increase. Reducing its operating leverage would decrease the firm’s cost of capital, because it would decrease the amount of risk that investors would perceive in the company.
An increase in the corporate tax rate would not cause the firm's cost of capital to increase. If the corporate tax rate increases, this will decrease the net amount of interest expense (after taxes) that the firm has to pay on its debt, and that would also decrease the firm’s cost of capital. To understand why this is so, suppose a company has net income before interest and taxes of $100,000. The tax rate is 40%. Interest expense is $10,000. So net income after subtracting interest expense is $90,000. Income tax is 40% of that, or $36,000, so net income after interest and taxes are deducted is $54,000. If the company had not had the interest expense, its net income before tax would have been $100,000. Its tax would have been $40,000, and its net income would have been $60,000. Therefore, the company’s interest expense, net of taxes, is the difference between $60,000 net income and $54,000 net income, which is only $6,000. That is less than the $10,000 that the company actually paid in interest. The reason is because taxes on the company’s net income reduced its effective interest rate. Now, suppose the income tax rate increases to 45%. Net income after subtracting interest expense is still $90,000. But now, income tax is 45% of that, or $40,500. Net income after tax is now $49,500. Let’s compare that again with what the company’s net income would have been without the interest expense. Net income would have been $100,000, and income tax would have been $45,000. The company’s net income would have been $55,000. So the company’s interest expense, net of taxes, is the difference between $55,000 net income without interest expense and $49,500 net income with interest expense, or $5,500. The net amount of interest expense, after taxes, for the company is actually less ($5,500 versus $6,000) than it was when the tax rate was 40%.
If the company pays off its only outstanding debt, its interest expense will go away completely. Remember that the weighted average cost of capital is the weighted average cost of all financing, debt and equity included. Debt generally has a lower cost of capital than equity, because of the effect of taxes which reduce the effective interest rate of debt (as illustrated above). So if the debt goes away, all that will be left is equity, and equity has a higher cost of capital than debt does. Therefore, the firm’s cost of capital will increase. If the Treasury Bond yield increases, this will also cause the firm’s cost of capital to increase. The yield on Treasury securities is determined by market supply and demand for those securities. When the market rate for Treasury securities (considered the risk-free rate) increases, usually corporate bond market rates also increase in order to maintain the same risk premium as previously. When market rates increase, the market price of existing securities decreases in order to make their market rate match the market yield. So corporate bonds’ market prices will decrease and their market rates will increase. Remember that cost of capital calculations are based on market prices of the stocks or bonds, not the issuing company’s book value for the stocks or bonds. So when the market prices of a firm’s outstanding corporate bonds decrease, the firm’s calculated cost of capital for those bonds will increase. When the firm’s cost of debt increases, the firm’s weighted average cost of capital will increase.
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