Which of the following statements is correct?
A)A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt.
B)The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price.
C)The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share.
D)If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.

Question

Quizplus · Accepted Answer

The statement that best explains the relationship between capital structure and firm value is B. This is because the capital structure that minimizes the weighted average cost of capital (WACC) leads to the highest stock price, as the cost of capital is reduced, which in turn increases the value of the firm. While statement A is partially correct in that retained earnings do not incur flotation costs, the cost of retained earnings is typically higher than the cost of debt as it is based on the opportunity cost of not distributing earnings to shareholders. Statement C is incorrect because minimizing the weighted average cost of capital does not necessarily equate to maximizing earnings per share. Finally, statement D is incorrect because increasing the debt ratio could increase the cost of equity, and therefore could increase the WACC.

Which of the Following Statements Is Correct