Question

To improve EVA, the firm should simply lower its debt ratio because a lower debt ratio reduces the cost of debt and thus the WACC of the firm." True or false? Select one: a. False b. True

Answer #1

Economic Value Add (EVA) = Net Operating profit after taxes - (Total Assets - Current Liabilities) * WACC.

And WACC = Debt ratio * after tax cost of debt + Equity ratio * cost of equity

So there are 2 components in WACC, equity and debt and cost of equity, as we know is always greater than cost of debt.

Now if we reduce debt ratio, it will reduce cost of debt portion in WACC, BUT, decrease in debt ratio will lead to increase in Equity ratio, which will increase the cost of equity portion.

Example : Lets assume :

Debt ratio = 0.6

After tax cost of debt = 5%

Equity ratio = 0.4

Cost of equity = 10%

**WACC = 0.6*5 + 0.4*10 = 7%**

New ratios

Debt ratio = 0.4

After tax cost of debt = 5%

Equity ratio = 0.6

Cost of equity = 10%

**WACC = 0.4*5 + 0.6*10 = 8%**

**So WACC increase by decreasing the debt ratio. So answer
is FALSE**

Suppose the debt ratio (Debt to total assets) is 30%, the
current cost of debt is 8%, the current cost of equity is 15%, and
the tax rate is 21%. A decrease in the debt ratio to 25% would
decrease the weighted average cost of capital (WACC).
a. True
b. False

A firm has a debt to equity ratio of 2/3. Its cost of equity
is 15.2%, cost of debt is 4%, and tax rate is 35%. Assume that the
risk-free rate is 4%, and market risk premium is 8%.
Suppose the firm repurchases stock and finances the
repurchase with debt, causing its debt to equity ratio to change to
3/2:
What is the firm’s WACC before and after the change in
capital structure?
Compute the firm’s new equity beta and...

The Total Debt to Total Capital ratio is an effective type of
debt management ratio because it gives an idea of
A. how profitably the firm is operating and utilizing its
assets.
B. the firm’s ability to pay off debts that are maturing within
a year.
C. how the firm has financed its assets as well as the firm’s
ability to repay its long-term debt.
D. how efficiently the firm is using its assets.

A firm has recently adjusted its capital structure from 30% debt
ratio to 50% debt ratio. Assume there are no other changes in the
market and all the assumptions of MM (with tax) hold. What will
happen to the values of the following items?
Present value tax shields
Answer 1Choose...IncreaseUnchangedDecrease
WACC before tax
Answer 2Choose...IncreaseUnchangedDecrease
Firm value
Answer 3Choose...IncreaseUnchangedDecrease
WACC after tax
Answer 4Choose...IncreaseUnchangedDecrease

Under proposition II, the required rate of return on the firm is
a linear straight line with an upward slope because:
Select one:
a. The weighted average cost of capital (WACC) is downward
sloping
b. As a firm increases its debt/equity ratio the risk of bankruptcy
is higher
c. As a firm increases its debt/equity ratio the net cashflow
increases.
d. The weighted average cost of capital remains the same no matter
the debt/equity ratio

A firm calculates its cost of debt and finds it to be 9.75%. It
then calculates its cost of equity capital and finds it to be
16.25%. The firm’s chairman tells the chief financial officer that
the firm should issue debt because it is cheaper than equity. How
should the chief financial offi- cer respond to the chairman? (You
may assume that the chief financial officer’s job is
secure!)
The cost of debt is always less than the cost of...

A firm should always use a full-service AD agency to carry out
its AD requirement
Select one
A. True
B. False

A company currently has the debt-to-equity ratio of 1/3. Its
cost of debt is 4% before tax and its cost of equity is 12%. Assume
that the company is considering raising the debt-to-equity ratio to
1/2. The tax rate is 20%. What is its new cost of equity under the
new debt-to-equity ratio? What is its new weighted average cost of
capital (WACC) under the new debt-to-equity ratio.

A company currently has the debt-to-equity ratio of 1/3. Its
cost of debt is 6% before tax and its cost of equity is 12%. Assume
that the company is considering raising the debt-to-equity ratio to
1/2. The tax rate is 20%. What is its new cost of equity under the
new debt-to-equity ratio? What is its new weighted average cost of
capital (WACC) under the new debt-to-equity ratio.

"If a negative EFN (External Financing Needed, aka AFN) is
lessening the firms debt because of the ability to pay off existing
debt, then it is also reducing the cost of capital. This means that
the firm does not have to use as many funds, as a percent (WACC),
in order to operate at a level of at least breaking even. If a firm
wants to reduce its WACC it should use its negative EFN to pay off
debt."
The...

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