Question

Contrary to the perfect capital market assumptions of Modigliani and Miller, the real world is messy and there are taxes, interest payments are tax deductible, there are costs of financial distress, etc. In our less than perfect world, which of the following are true?

A. Firm value INCREASES and WACC DECREASES initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value starts to DECREASE and WACC starts to INCREASE as more debt is added.

B. Firm value and WACC are INDEPENDENT of the firm's capital structure.

C. Each firm has an optimal capital structure where WACC is maximized.

D. Each firm has an optimal capital structure where firm value is minimized.

E. Firm value INCREASES and WACC Increases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value and WACC start to DECREASE as more debt is added.

Please explain why!

Answer 1

A. Firm value INCREASES and WACC DECREASES initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value starts to DECREASE and WACC starts to INCREASE as more debt is added.

The above statement is True as debt has interest tax benefits which reduce the cost of capital thereby increasing the value of the firm.

B. Firm value and WACC are INDEPENDENT of the firm's capital structure.

Wacc is the weighted average cost of capital ie the proportion of debt and equity in a capital structure. Thus, WACC directly impacts the capital structure and the firm value in process. The statement is False.

C. Each firm has an optimal capital structure where WACC is maximized

The statement is False as optimal capital structure is chosen by various combination of debt and equity such that the WACC is minimized and the firm value is maximised.

D)  Each firm has an optimal capital structure where firm value is minimized.

Optimal capital structure is one where the wacc is minimized and firm value is maximized. The statement is False

E. Firm value INCREASES and WACC Increases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value and WACC start to DECREASE as more debt is added

As more debt is added to the capital structure, the after tax benefits of debt reduces the overall WACC, increasing the firm value. However there comes a point when any addition of debt creates a potential distress costs that outweigh the benefits of reduced taxes. After this point , WACC starts to increase and firm value decreases.

The statement is False