1

Which statement about capital structure is the most correct?

a.

A company should always try to reduce its debt because of the high bankruptcy risk associated with debt. A company should aim to have 100% equity financing if it is possible.

b.

Because the cost of debt is cheaper than the cost of equity, a company should use as much debt as possible to finance their projects

c.

The more the company borrows, the higher will be its tax shields, therefore a company will always prefer to issue debt than equity.

d.

Lenders rank ahead of shareholders when the company goes bankrupt. This increased risk for shareholders means the cost of equity is higher than the cost of debt.

e.

The more the company borrows, the lower will be the after-tax WACC. This increases the present value of the firm free cash flows which represents the value of the levered firm. Therefore, a firm should always seek to borrow as much debt as possible.

2

Which of the following would increase a firms WACC before tax?

a.

A firm issues bonds and uses the proceeds to repurchase stock.

b.

A firm invests in an average-risk project using equity, rather than debt financing.

c.

A pharmaceutical research company develops a 100% effective COVID vaccine, which reduces its systematic risk in the market.

d.

A firm issues shares and uses the proceeds to pay off a bank loan.

e.

A supermarket chain decides to establish hardware stores which increases its sensitivity to market fluctuations.