Question

how does the level of debt affect the weighted average cost of capital (wacc)? multiple choice question. the wacc always increases as debt increases. the wacc initially falls and then rises as debt increases. the wacc always falls as debt increases. the wacc initially rises and then falls as debt increases.

Answer 1

The WACC initially decreases due to the interest tax shield effect of debt but eventually increases as too much debt raises financial risk. Increased U.S. public debt may make the U.S. less attractive to foreign investors, influencing the supply of financial capital. The correct answer is option: b) the wacc initially falls and then rises as debt increases.

Step-by-step explanation:

The question concerns how the level of debt affects the weighted average cost of capital (WACC). The correct response to the multiple-choice question is that the WACC initially falls and then rises as debt increases.

This phenomenon is due to the interest tax shield which makes debt financing cheaper up to a certain point, but as debt levels rise too high, the cost of debt increases due to increased financial risk, and therefore the WACC also starts to rise.

Additionally, when there is increased fear of U.S. public debt, foreign investors may find the U.S. economy less desirable, affecting the supply of financial capital.

Higher public debt would typically lead to increased interest rates for borrowing, both for the government and businesses as they compete for financial resources, potentially affecting the equilibrium price and quantity for capital in U.S. financial markets.