Question

Which of the following statements is most correct?

a. The optimal capital structure minimizes the WACC. b. If the after-tax cost of equity financing exceeds the after-tax cost of debt financing, firms
are always able to reduce their WACC by increasing the amount of debt in their capital
structure.
c. Increasing the amount of debt in a firm’s capital structure is likely to increase the costs of
both debt and equity financing.
d. Statements a and c are correct.
e. Statements b and c are correct.

Answer 1

The most correct statement is "Statements b and c are correct."

Step-by-step explanation:

The optimal capital structure is the one that minimizes the firm's weighted average cost of capital (WACC), which is the average cost of all the different sources of financing the firm uses (e.g. debt, equity, etc.). If the after-tax cost of equity financing exceeds the after-tax cost of debt financing, firms can reduce their WACC by increasing the amount of debt in their capital structure. However, increasing the amount of debt in a firm's capital structure is likely to increase the costs of both debt and equity financing, as creditors and investors may require higher returns to compensate for the increased risk of the firm's capital structure. Therefore, statements b and c are correct. Statements a and d are incorrect because they do not accurately reflect the relationship between the firm's capital structure and its WACC.

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