Question

Hello I have a question.

Which of the following statements is true?

As a general rule,the capital structure that:

a-Maximizes expected EPS also maximizes the price per share of common stocks.

b-minimizes the required rate on equity also maximizes the stock price.

c-Maximizes the price per share of common stock also minimizes the weighted average cost of capital.

d-None of the above

Can you please explain the answer and give some general details about the WACC and how is it affected by the changes? Thank you

Answer 1

Answer:

Correct answer is:

c - Maximizes the price per share of common stock also minimizes the weighted average cost of capital

Explanation:

Option C is correct and other options A, B and D are incorrect since:

Weighted average cost of capital (WACC) = Cost of equity * Weight of equity + Cost of debt * (1 - Tax rate) * Weight of debt

In an all equity firm, when debt is introduced initially it reduces WACC (since interest is tax deductible) and increases EPS, ROE and share value. However, as more and more debt is introduced banks will charge higher interest as risk increases. This impacts cost of equity also. Hence debt equity ratio should be such that resultant WACC is minimum. The Capital structure which minimizes WACC is an optimal capital structure and at this capital structure EPS, ROE and share value will be maximum.