CMA Study Group

cma part 2 question

  • 1.  cma part 2 question

    Posted 26 days ago

    what is the relationship of increase in treasury bond yield with increase in cost of capital? point number 4

    Which of the following, when considered individually, would generally have the effect of increasing a firm's cost of capital?
    1. The firm reduces its operating leverage.
    2. The corporate tax rate is increased.
    3. The firm pays off its only outstanding debt.
    4. The Treasury Bond yield increases.
    Answer (B) is correct.
    Debt generally has a lower initial cost than equity. By removing debt from the firm's financing structure, the cost of capital is thereby increased. Similarly, the increase in yield on Treasury bonds, a risk-free rate, would cause the yield on all other bonds to also increase.


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    Tayba Al-Mehdar
    Analyst
    Khobar
    Saudi Arabia
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  • 2.  RE: cma part 2 question

    Posted 26 days ago
    Hi, Tayba Al-Mehdar

    This is little tricky question here The Treasury Bond yield increases means Risk Free rate increase. However when I tried to increase interest free rate in the CAPM formula it reduces the internal rate of return which cost of capital on the other side. Got confused also. 


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    Badar Ghafoor
    Accountant
    Dubai
    United Arab Emirates
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  • 3.  RE: cma part 2 question

    Posted 26 days ago
    I am confused, increasing the risk free return rate will increase the internal rate of return. So that is the reason.

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    Ashvin Kulkarni
    Accountant
    Pune
    India
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  • 4.  RE: cma part 2 question

    Posted 24 days ago
    Hello Guys,

    I think the increase in treasury bonds cost, makes other debt finance more costly to the firm, so when you try to finance your needs through debt it will be expensive.

    Mostafa Elmahy
    Credit Controller
    Riyadh

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    MOSTAFA ISMAIL MAHMOUD MAHY
    Accountant
    Cairo
    Egypt
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  • 5.  RE: cma part 2 question

    Posted 24 days ago
    Hi Tayba,

    Let me try and answer this.

    In Corporate Financing, when  companies try to source or arrange capital, it involves  two major parties(i am excluding the intermediaries like investment banks just to simplify the answer).

    The first party is the person who is looking to invest her money in the most profitable opportunities(aka Investor)

    The second party is the Company which is in need of capital.(aka Investee)

    Lets say -- Tayba is Investor, ABC Inc is Investee. Tayba is considering to invest her money in ABC Inc.

    Now, the rate of return expected by Tayba(from her investment in ABC) will become the Cost of Capital for ABC Inc.

    When Tayba calculates her expected rate of return, she uses CAPM method. In CAPM formula, we use the Risk free rate(which is nothing but the Treasury yield).

    So, when risk free rate goes up, Tayba's Expected Rate of Return goes up which would also mean that ABC Inc's Cost of Capital sourced from Tayba will go up. This is because Tayba's expectation is ABC Inc's cost.

    I know its a very long answer. Hopefully it helps. Also, if there are any contradictory understandings,  please let me know. All the best

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    Badrinath Gopal
    India
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