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You are a financial analyst for a small startup firm in the Pocatello area. Your company...

You are a financial analyst for a small startup firm in the Pocatello area. Your company currently has 40% debt in its capital structure, and the cost of debt is 8%, the cost of equity is 15%. The controller reasons that if the company increases the amount of debt to 70% then the firm’s cost of capital will decrease because the cost of debt is only 8%. She states that now previously unprofitable projects will be profitable and current profitable projects will be even more so. Do you agree or disagree with her? Explain why? (4 pts)

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Answer #1

I will completely disagree with her. According to modiglani and miller approach in a tax free world firm wacc will we same for any mix in capital approach.but in a tax world where interest expense can be tax deductible using debt to a certain extent will lower wacc. But increasing debt beyond limits equity holders will become risk averse and cost of equity will raise so wacc will not be lowered. This is the reason if she raise debt to 70% cost of equity will increase. So i completely disagree with her

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