C5

• why it is more appropriate to use the after-tax cost of debt rd (1-T) than before-tax cost of debt in the calculation of WACC.

  shareholders are interested in maximizing the value of the firm’s stock, and the stock price depends on after-tax cash flows.
• why retained earning has a cost.

  ▪ Retained earnings incur “opportunity cost”. ➔ the return that stockholders could earn on alternative investments.

  ▪ Example, if earnings distributed as dividend, common stockholders use to invest in other stocks, bonds, real estates, or other investment,

  earning a return rs.

  ▪ Firm needs to earn at least as much on any earnings retained (rs), as the stockholders could earn on alternative investments of comparable risk.
• pecking order theory in capital structure.

  Pecking order hypothesis, a firm use retained earnings (internal

  financing) as the preferred choice of raising capital. If not sufficient to cover capital requirement, issue new debts. If both retained

  earnings and debts are not sufficient, issue new common stocks.

  Retained earnings is the preferred choice for a firm is because no flotation cost is incurred from the use of internal fund. Besides, since retained earnings is internal fund, it minimises information asymmetry and therefore is cheaper than external sources.
• If retained earnings is not sufficient and the firm has to raise capital from external sources, it should issue new debts because the cost of issuing new debts is relatively low. Besides, the issuance of new debt is usually treated as a positive signal by the market as it shows that the firm is confident about its ability to service its debts in future.
• A firm should treat issuance of new common stocks as last resort due to high floatation cost incurred in issuance of new equity. Moreover, there exists a “signaling effect” when a firm decides to issue new common stocks. Market perceives issuance of new common stocks as negative signal that the firm’s stock is overvalued and the firm is taking opportunity to sell new stocks when its market price is relatively high. Empirical studies have shown that when a firm announces a new stock offering, more often than not, the price of its stock will decline.