Question

For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT? A) The company's weighted average cost of capital (WACC) will be equal to the cost of debt. B) The company's cost of equity will always be higher than the cost of debt. C) The company's financial risk will decrease if it increases its use of common equity. D) The company's WACC will be a weighted average of the cost of debt and the cost of equity, with weights of 50% each.

Answer 1

The company's WACC will be the weighted average of the cost of debt and the cost of equity, with equal weights for each since the capital structure is 50% debt and 50% equity.

Step-by-step explanation:

The correct answer to the question is D) The company's Weighted Average Cost of Capital (WACC) will be a weighted average of the cost of debt and the cost of equity, with weights of 50% each. This is because WACC is calculated by taking the proportion of each component of capital (equity and debt), multiplying it by the respective cost (after-tax cost of debt and cost of equity), and summing the results. In a company where the capital structure is 50% debt and 50% common equity, each component contributes equally to the WACC.

Statement A is incorrect, as the WACC is not simply equal to the cost of debt. Statement B could be true, but it is not always the case. Generally, equity is more expensive than debt due to the higher risk equity investors bear, but this statement is not absolute. Statement C is somewhat true because the use of equity does not carry the same financial risk as debt, but the question asks for information specifically related to the capital structure's impact on WACC, making D the most correct answer for the context provided.

Answer 2

The company's WACC will be the weighted average of its cost of debt and cost of equity, with both contributing 50% since the company’s target capital structure is evenly split between debt and equity.

Step-by-step explanation:

The correct answer to the question is D) The company's WACC will be a weighted average of the cost of debt and the cost of equity, with weights of 50% each. This is because the Weighted Average Cost of Capital (WACC) represents the average rate that a company is expected to pay to finance its assets, weighted based on the proportion of each financing source in the overall capital structure. Therefore, WACC is not simply the cost of debt and is influenced by both the cost of debt and the cost of equity. Cost of equity will generally be higher than the cost of debt because equity investors require a risk premium for the additional risks they take on compared to debt holders.

Alternatively, increasing the use of common equity (Statement C) may reduce the financial risk because there would be less debt and thus lower financial leverage. However, this does not impact the WACC directly, unless the costs of debt or equity are altered as a result.