According to __________, a firm's cost of equity increases with greater debt financing, while the WACC first decreases and then increases.

Question

Quizplus · Accepted Answer

The static theory of capital structure suggests that there is an optimal capital structure where the weighted average cost of capital (WACC) is minimized. According to this theory, as a firm increases its use of debt financing, its cost of equity does indeed increase due to the higher risk perceived by equity investors. Initially, the benefit from the tax shield of debt causes the WACC to decrease, but as the firm takes on more debt, the increased financial risk leads to a higher cost of equity and debt, causing the WACC to eventually increase. This theory captures the trade-off between the tax benefits of debt and the costs of financial distress.

According to __________, a Firm's Cost of Equity Increases with Greater