Question

For a firm that is financed by debt and equity, an increase in the percentage of debt-financing

a)

will decrease WACC if the rate of return for debt holders is greater than the rate of return for equity holders.

b)

will increase WACC if the rate of return for debt holders is less than the rate of return for equity

holders.

c)

both a) and b) are correct.

d)

neither a) nor b) are correct.

e)

will increase WACC if the rate of return for debt holders is greater than the rate of return for equity holders.

f)

will decrease WACC if the rate of return for debt holders is less than the rate of return for equity holders.

Please explain answer.

Answer 1

Simplistic representation of WACC is Wd(cost of debt)+We(cost of equity).

Wd+We=1

Now if Cost of debt > Cost of equity then increase in weight of debt financing will increase WACC

HENCE OPTION E IS correct for sure