1)Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few years whether or not the firm uses debt financing

Which of the following statements is most correct?

1) Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few years whether or not the firm uses debt financing. Then the firm's after-tax cost of debt will equal its before-tax cost of debt.

2) The component cost of preferred stock is expressed as kps(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.

3) The reason that a cost is assigned to retained earnings is because these funds are already earning a return in the business; the reason does not involve the opportunity cost principle.

4) The bond-yield-plus-risk-premium approach to estimating a firm's cost of common equity involves adding a subjectively determined risk-premium to the market risk-free bond rate.

5) All of the statements above are false.

Answer: 1. Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few years whether or not the firm uses debt financing. Then the firm's after-tax cost of debt will equal its before-tax cost of debt.
This is correct because if the company is not paying any taxes then the tax shield on interest payments on debt does not materialize.

2) Is incorrect as dividends are not tax free and therefore adjustments for tax benefits are not to be applied to preferred stock.

3) Is incorrect. Retained earning involves opportunity cost.

4) Is incorrect. The bond-yield-plus-risk-premium approach to estimating a firm's cost of common equity involves adding a subjectively determined risk-premium to the COMPANY'S OWN long term debt.