A firm currently has a debt-equity ratio of 50%, an after-tax cost of debt of 8%, and a cost of equity of 12%. The firm changes its debt-equity ratio to 40%, all else constant. This change will: • Increase the total debt level of the firm. • Decrease the cost of equity financing. • Cause the NPV of projects under consideration to decrease. • Decrease the firm\'s WACC. • Not affect the firm\'s capital budgeting decisions. Answer:
Solution
Net present value:
= Present value of cash inflows-Present value of cash outflows
If the firm WACC is least, net present value will be optimum. WACC and net present value has inverse relationship if the one is at its least another will be at its maximum and vice-versa.
Hence, correct option is Cause the NPV of projects under consideration to decrease.
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A firm currently has a debt-equity ratio of 50-- an after-tax cost of.docx
1. A firm currently has a debt-equity ratio of 50%, an after-tax cost of debt of 8%, and a cost of
equity of 12%. The firm changes its debt-equity ratio to 40%, all else constant. This change will:
• Increase the total debt level of the firm. • Decrease the cost of equity financing. • Cause
the NPV of projects under consideration to decrease. • Decrease the firm's WACC. • Not
affect the firm's capital budgeting decisions. Answer:
Solution
Net present value:
= Present value of cash inflows-Present value of cash outflows
If the firm WACC is least, net present value will be optimum. WACC and net present value has
inverse relationship if the one is at its least another will be at its maximum and vice-versa.
Hence, correct option is Cause the NPV of projects under consideration to decrease.
WACC = Wd×Rd×(1-
t)+We×Ke
W is weights of respective portfolios
R is return on respective portfolios
Cost of equity 12.00%
After tax cost of debt 8.00%
Equity weight 0.67
Debt weight 0.33
WACC (Old) 10.67%
Cost of equity 12.00%
After tax cost of debt 8.00%
Equity weight 0.71
Debt weight 0.29
WACC (New) 10.86%
WACC is increased
