Which of these will occur in a world with taxes and financial distress when a firm is operating at its optimal capital structure? I.The debt-equity ratio will be optimal.
II)The weighted average cost of capital will be at its minimal point.
III)The required return on assets will be at its maximum point.
IV)The increased benefit from additional debt will equal the increased bankruptcy costs of that debt.
A)I and IV only
B)II and III only
C)I and II only
D)II,III,and IV only
E)I,II,and IV only

Question

Quizplus · Accepted Answer

In an optimal capital structure, the debt-equity ratio is at a level where the firm minimizes its weighted average cost of capital (WACC) and balances the benefits of debt (such as tax shields) against the costs of financial distress. This means that the WACC is at its lowest point, not the required return on assets at its maximum. The increased benefit from additional debt will indeed equal the increased bankruptcy costs of that debt, indicating a balance between the advantages and disadvantages of debt financing.

Which of These Will Occur in a World with Taxes