Which of the following statements is CORRECT?
A) Since debt financing raises the firm's financial risk,increasing the target debt ratio will always increase the WACC.
B) Since debt financing is cheaper than equity financing,raising a company's debt ratio will always reduce its WACC.
C) Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing.However,this action still may raise the company's WACC.
D) Increasing a company's debt ratio will typically increase the marginal costs of both debt and equity financing.However,this action still may lower the company's WACC.
E) Since a firm's beta coefficient is not affected by its use of financial leverage,leverage does not affect the cost of equity.

Question

Quizplus · Accepted Answer

Increasing a company's debt ratio generally increases the marginal costs of both debt and equity financing due to the increased financial risk. However, because debt financing is cheaper than equity financing, this action can still potentially lower the company's weighted average cost of capital (WACC) up to a certain point. Beyond that point, the increased costs of debt and equity due to higher risk may outweigh the benefits of cheaper debt financing, thus increasing the WACC.

Which of the Following Statements Is CORRECT