Variable Cost and Capital Structure

Good Essays
1. Which of the following would increase the likelihood that a company would increase its debt ratio in its capital structure?
a. An increase in costs incurred when filing for bankruptcy.
b. An increase in the corporate tax rate.
c. An increase in the personal tax rate.
d. None of the statements above is correct.

ANSWER: B An increase in the corporate tax rate would mean that firms would get larger tax breaks for interest payments. Therefore, firms have an incentive to increase interest payments, in order to reduce taxes. Therefore, they will increase their debt ratios.

2. Which of the following events is likely to encourage a company to raise its target debt ratio? a. An increase in the corporate tax rate. b. An increase in the personal tax rate. c. An increase in the company’s operating leverage. d. Statements a and c are correct.

ANSWER: A An increase in the tax rate would lower the after-tax cost of debt relative to equity; therefore, this would encourage a company to raise its target debt ratio.

3. Which of the following statements is most correct?

a. Since debt financing raises the firm 's financial risk, raising a company’s debt ratio will always increase the company’s WACC.
b. Since debt financing is cheaper than equity financing, raising a company’s debt ratio will always reduce the company’s WACC.
c. Increasing a company’s debt ratio will typically reduce the marginal cost of both debt and equity financing; however, it still may raise the company’s WACC. d. None of the statements above is correct.

ANSWER: D

4. Which of the following statements is most correct?
a. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.
b. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
c. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
d. None of the statements above is

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