Question

Q1

a)

Which one of the following statements is true regarding financial slack? Financial Slack:

		allows firms to take advantage of good investment opportunities
		is always associated with high leverage
		reduces agency problems for the firm
		increases the need for managers to seek external financing

b)

According to the Trade-Off Theory of Debt Policy, beyond a certain point of debt financing, increasing debt further will do all of the following  EXCEPT:

		cause stockholders to demand a higher return.
		cause investors to demand a higher interest rate on debt.
		increase the risk to the firm's common stockholders.
		decrease the firm's cost of common equity.

c)

Tax Effect. Which one of the following statements is TRUE. An increase in a corporation's tax rate will cause:

		a decrease in an unleveraged firm's cost of equity.
		an increase in the value of an unleveraged firm.
		a decrease in a leveraged firm's WACC.
		an increase in a leveraged firm's cost of debt.

Answer 1

Q1a) allows firms to take advantage of good investment opportunities.

Explanation: Financial slack is the unused capital kept by firms to be used in the time of emergency. This financial slack maintained by companies provide them with the opportunity to invest in good projects.

Qb) Decrease the firm's cost of common equity

Explanation: An increase in debt above a certain point, increases the risk for the stakeholders. Hence, due to increase in the risk, the shareholders demand more return leading to increase in cost of common equity. So, this statement is wrong.

Qc) A decrease in a leveraged firm's WACC

Explanation: An increase in corporate tax decreases the cost of debt and hence decreases the WACC.