Final answer:
The WACC initially decreases as a firm's debt/equity ratio falls due to tax benefits. Beyond a certain point, as more debt is used, WACC rises because of increased financial risk. An increased supply of capital in the financial markets leads to lower interest rates.
Step-by-step explanation:
According to Traditional Theory, as a firm's debt/equity ratio falls, the firm's overall cost of capital, known as the Weighted Average Cost of Capital (WACC), initially decreases due to the tax benefits of debt. However, after a certain point, as debt increases to higher levels relative to equity, the cost of debt rises due to increased financial risk, and consequently, the WACC starts to rise. Thus, the correct answer to the student's question is that the WACC falls then rises (answer a). This reflects an optimal debt/equity ratio at which the WACC is minimized.
In terms of changes in the financial market that could lead to a decline in interest rates, the correct answer is that an increase in the supply of capital will generally cause interest rates to fall (answer c). The reason for this is that with more funds available to lend (a larger supply), lenders will reduce the interest rates to attract borrowers.