Question

A policy of maximizing the value of the firm is the same as a policy of minimizing the weighted average cost of capital providing that

I) the firm's investment policy is settled;
II) there are no taxes;
III) an issue of new debt does not affect the market value of existing debt

A. I, II, and III
B. II only
C. I only
D. III only

Answer 1

Option A (I, II, and III) is the correct choice because for maximizing a firm's value to be equal to minimizing the weighted average cost of capital, all the three conditions must be met: a settled investment policy, no taxes, and new debt issuance not affecting existing debt's market value.

Step-by-step explanation:

The question pertains to the relationship between a firm's policy of maximizing its value and minimizing its weighted average cost of capital (WACC). A firm that maximizes its value does so by investing in projects that earn a rate of return higher than the cost of capital, effectively lowering the WACC. However, for the policy of maximizing the value of the firm to be synonymous with minimizing WACC, certain conditions have to be met: the firm's investment policy must be fixed (I), there should be no taxes impacting the cost of capital (II), and the issuance of new debt should not affect the value of existing debt (III).

When perfectly competitive firms maximize their profits by producing where price (P) equals marginal cost (MC), they achieve a state where the benefits to consumers (price they are willing to pay) match the costs to society of producing additional units (marginal costs). This ensures that allocative efficiency is maintained, meaning that resources are allocated in the most efficient manner, maximizing societal benefit.

The correct answer to the question would be Option A, which includes all three statements (I, II, and III), aligning with the condition that the policy of maximizing the firm's value is the same as the policy of minimizing the WACC, assuming all given conditions are in place.

Answer 2

The query examines the conditions where maximizing firm value corresponds to minimizing the firm's weighted average cost of capital, especially when the firm's investment policy is set, there are no taxes influencing finances, and new debt does not impact the value of existing debt.

Step-by-step explanation:

The question posed is related to the concept of maximizing a firm's value by minimizing costs, specifically in relation to the weighted average cost of capital (WACC). The provided options touch upon different conditions under which a policy of maximizing the value of the firm is equivalent to a policy of minimizing the WACC.

Maximizing the value of the firm typically aligns with minimizing the WACC under certain assumptions. One key assumption is that the firm's investment policy is settled, meaning that the investment decisions are fixed and not influenced by financing decisions. It is also assumed that there are no taxes, which would affect the costs associated with debt and equity financing, and thus influence the WACC. Lastly, it is assumed that issuing new debt does not affect the market value of the existing debt, which would otherwise cause a shift in the WACC.

In the broader context of market efficiency, when perfectly competitive firms maximize profits by producing at the point where the price (P) equals the marginal cost (MC), it is believed that social welfare is maximized. This condition ensures that the benefits to consumers, as reflected by the price, are equal to the societal costs of production.