Which of the following statements is correct?
A)The capital structure that maximizes the common share price is also the capital structure that minimizes the WACC.
B)The capital structure that maximizes the common share price is also the capital structure that maximizes earnings per share.
C)Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing; however, this still may raise the company's WACC.
D)Increasing personal tax rate but decreasing corporate tax rate would encourage companies to increase their debt ratios.

Question

Quizplus · Accepted Answer

The capital structure that maximizes the common share price is also the capital structure that minimizes the WACC. This is because the WACC is a weighted average of the costs of equity and debt, and as the proportion of debt in the capital structure increases, the cost of equity decreases due to the tax shield provided by debt. However, if the debt ratio is too high, the cost of debt may start to increase, leading to an overall increase in the WACC. Therefore, the optimal capital structure is the one that balances the benefit of debt with its associated cost. Earnings per share may not necessarily be maximized under this optimal capital structure. Option C is partially correct but incomplete, and option D is incorrect; increasing personal tax rates would reduce the tax shield benefit of debt, thereby discouraging companies from increasing their debt ratios.

Which of the Following Statements Is Correct