To determine which statement is correct regarding the given financial concepts, let's break down each of the provided options:
1. "The weighted average cost of capital is calculated on a before-tax basis." (False)
- The weighted average cost of capital (WACC) takes into account the after-tax cost of debt, not before-tax, because interest expense is tax-deductible. The formula typically used is:
[tex]\[
WACC = \left(\frac{E}{V} \times Re\right) + \left(\frac{D}{V} \times Rd \times (1 - Tax Rate)\right)
\][/tex]
Where [tex]\( E \)[/tex] is the market value of equity, [tex]\( D \)[/tex] is the market value of debt, [tex]\( V \)[/tex] is the total market value of the firm’s financing (equity + debt), [tex]\( Re \)[/tex] is the cost of equity, and [tex]\( Rd \)[/tex] is the cost of debt.
2. "An increase in the market risk premium is likely to increase the weighted average cost of capital." (True)
- The market risk premium is a component of the cost of equity, which is calculated using the Capital Asset Pricing Model (CAPM):
[tex]\[
Re = Rf + \beta \times (Rm - Rf)
\][/tex]
Here, [tex]\( Rf \)[/tex] is the risk-free rate, [tex]\( \beta \)[/tex] is the beta coefficient (measure of a stock's volatility relative to the market), and [tex]\( Rm - Rf \)[/tex] is the market risk premium. An increase in the market risk premium ([tex]\( Rm - Rf \)[/tex]) would lead to an increase in the cost of equity ([tex]\( Re \)[/tex]), thereby increasing the WACC.
3. "The weights of debt and equity should be based on the balance sheet because this is the most accurate assessment of the valuation." (False)
- The weights in the WACC formula should be based on market values rather than book values from the balance sheet. Market values provide a current and forward-looking assessment of the firm's worth, while book values may be historical and not reflective of current market conditions.
4. "All of these choices are correct." (False)
- As we evaluated, not all the provided statements are correct. Therefore, this option is incorrect too.
Based on the analysis and understanding of each statement, the correct answer is:
"An increase in the market risk premium is likely to increase the weighted average cost of capital."
