Multiple Choice Circle the best response 2 points each 1 A f

Multiple Choice. Circle the best response. 2 points each.

1. A firm’s income tax rate has decreased in 2018.

a. Its cost of debt capital will increase.

b. Its cost of debt capital will decrease.

c. Its cost of common equity capital will increase.

d. Its cost of common equity capital will decrease.

2. The optimum capital structure is the one which results in the

a. the highest weighted average cost of capital.

b. more equity than debt.

c. less equity than debt.

d. the lowest weighted average cost of capital.

3. Assume a firm increases long-term liabilities in its capital structure. If the bankruptcy effect is greater than the tax effect,

a. the weighted average cost of capital will increase.

b. the weighted average cost of capital will decrease.

c. the weighted average cost of capital will not change.

d. the weighted average cost of capital may increase or decrease.

Solution

Question 1. Option a

Cost of debt is calculated on a post tax basis while calculating WACC.

Post tax Cost of debt = Pretax Cost of Debt * (1 - Tax rate)

As tax rate decreases, post tax cost of debt would reduce and hence Option a is our answer.

Question 2. Option d is answer

Optiomal capital structure is defined as that mix of the capital constitutents where the weighted average cost of capital for firm would be lowest. Lowest WACC means lowest finance cost and hence higher profitability and chances of viability.

Question 3. Option a is answer

Higher bankruptcy effect would lead to higher risk of default. This would increase the cost of debt significantly. Higher cost of debt would lead to higher WACC, given tax rate would not be able to mitigate the cost of debt to extent or weigh out the effect of bankruptcy on cost of debt.