When a firm with a high market-beta merges with a firm with a lower market-beta,
A)the cost of capital of the combined firm will be a weighted average of the costs of capital for the individual firms.
B)investors will require a lower rate of return on the combined firm than they would have for each individual firm due to greater diversification.
C)the cost of capital of the combined firm will be lower due to greater diversification.
D)Both A and B are correct statements.

Question

Quizplus · Accepted Answer

The cost of capital of the combined firm will be a weighted average of the costs of capital for the individual firms. This is because beta is a measure of systematic risk and is reflected in the cost of equity capital, and when two companies merge, their betas are combined based on their relative weights in the new company. Option B is incorrect because investors may perceive the combined firm to have greater risk due to the higher market-beta of one of the merging firms. Option C is also incorrect because the cost of capital may not necessarily decrease due to diversification alone. The cost of capital of the combined firm will be a weighted average of the costs of capital for the individual firms. This is because the beta of the combined firm will be a weighted average of the betas of the individual firms. Therefore, the overall risk and required rate of return for the combined firm will be determined by the combination of the two individual firms' risks and required rates of return. The statement in B is incorrect because investors will not necessarily require a lower rate of return on the combined firm, as the level of diversification is dependent on the specific merger and the risks involved. The statement in C is also incorrect because diversification does not necessarily lower the overall cost of capital of a firm.

When a Firm with a High Market-Beta Merges with a Firm