Question

What will be the effect of using the book value of debt in WACC decisions if interest rates have decreased substantially since a firm's long-term bonds were issued?

A. The debt-to-value ratio will be overstated.

B. The debt-to-value ratio will be understated.

C. There will be no effect on WACC decisions.

D. It cannot be determined without knowing interest rates.

 

Answer 1

What will be the effect of using the book value of debt in WACC decisions if interest rates have decreased substantially since a firm's long-term bonds were issued?

B. The debt-to-value ratio will be understated.

 

MV Equity = 5 million

MV Debt = 2 million

Value of firm = 7 million

D/V = 5/7 = 0.286.

 

if MV Debt = 2.5 million, then

MV of firm = 7.5 million

then DV = 2.5/7.5 = 0.333

B. The debt-to-value ratio will be understated.