Which of the following statements is CORRECT? Answer a. Since debt financing rai

Question

Which of the following statements is CORRECT?
Answer
a. Since debt financing raises the firm's financial risk, increasing the target debt ratio will always increase the WACC.
b. Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing. However, this action still may raise the company's WACC.
c. Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC.
d. Since a firm's beta coefficient is not affected by its use of financial leverage, leverage does not affect the cost of equity.
e. Increasing a company's debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company's WACC.

Explanation / Answer

(Key) Statement a is false; if you are to the left of the firm's optimal capital structure on the WACC curve, raising a company's debt ratio will actually decrease the firm's WACC. Statement b is false; if you are to the right of the firm's optimal capital structure on the WACC curve, raising a company's debt ratio will actually increase the firm's WACC. Statement c is false; as you increase the firm's debt ratio the cost of debt will increase because you're using more debt. Because you're using more debt the cost of equity increases because the firm's financial risk has increased. From statements a and b you can see that whether the WACC is increased depends on where you are on the WACC curve relative to the firm's optimal capital structure. Therefore, the correct answer is statement e.

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