Question 69 interest tax shield, capital structure, leverage, WACC
Which statement about risk, required return and capital structure is the most correct?
(a) The before-tax cost of debt is less than the before-tax cost of equity. Therefore debt is a cheaper form of financing than equity so companies should try to finance their projects with debt only.
(b) Debt makes a firm's equity more risky. Therefore the higher the amount of debt, the higher the cost of equity.
(c) The more debt a firm has, the higher its tax shields. Therefore firms should seek to have as much debt and as little equity as possible.
(d) The more debt, the lower the firm's after tax WACC. The after tax WACC is the discount rate that discounts the firm's cash flows, so the lower it is the more the firm is worth. Therefore firms should try to make their after tax WACC as low as possible by using as much debt as possible.
(e) The less debt, the lower the chance of bankruptcy. Therefore firms should try to pay off all of their debt so that they are financed by equity only.