In a perfect world with no taxes, if a firm decides to increase its debt-to-equity ratio, the firm’s weighted average cost of capital (WACC) will ________________.
| a. |
Decrease |
|
| b. |
Remain the same |
|
| c. |
First decrease, then increase |
|
| d. |
Increase |
WACC = (Equity value*Cost of equity)/Total Capital + Debt Value*cost of Debt *(1-taxes Rate)/ Total Capital
WACC comprises of both Equity as well as Debt Funds.
Now, Debt funds are relatively cheaper to the company as they have provide tax benefits while the cost of equity doesn't provide any tax benefit but their cost is not pre-defined and its also not necessary to pay them every fiscal year.
If there are no taxes then Cost of Debt will not be cheaper anymore. so the cost of the capital will definitely increase, comparatively, when debt is increased in the Debt Equity Ratio.
So, Option d is correct.
In a perfect world with no taxes, if a firm decides to increase its debt-to-equity ratio,...