13. Which one of the following is false? a. In a world where interest is not tax

Question

13. Which one of the following is false?

a. In a world where interest is not tax deductible, a firm’s capital structure is irrelevant meaning that WACC is constant for all levels of D/E

b. The WACC always reflects the required return on a firm’s assets regardless of whether or not interest expense is tax deductible.

c. If interest expense is a tax deductible, a new asset is created that equals the present value of the interest tax shield. This new asset is a wealth transfer from the Federal Government (IRS) to the company’s shareholders.

d. A firm’s cost of equity increases with increasing D/E due to greater financial risk associated with higher leverage

e. In a world where interest expenses is tax deductible and bankruptcy costs are high, there is an optimal capital structure that maximizes the value of the firm. This occurs when the increase in the interest tax shield is offset by higher expected bankruptcy costs.

f. When using the beta of a comparable “pure play” firm to find the cost of capital of a privately held company, one only needs to consider the business risk. Adjusting for the financial risk of the comparable firm is not relevant when using its beta.

Explanation / Answer

Answer is (b) The WACC always reflects the required return on a firm’s assets regardless of whether or not interest expense is tax deductible.

WACC means Weighted Average Cost of Capital ,which represents weighted cost of all the funds invested in the Business.

For any business WACC is the minimum required return for to meet the finanial cost , any surplus over financial cost is profit to the business

But in this case Tax was taken as irrelevant factor for interest expence ,which is inconsistant with the above statement.

Tax on Interest creates finance leverage which reduce the interest expence hence ultimately reduces the WACC , hence the above statement is incorrect.

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