Question

1. The optimal capital structure has been achieved when the: A) debt-equity ratio is equal to 1. B) weight of equity is equal to the weight of debt. C) cost of equity is maximized given a pretax cost of debt. D) debt-equity ratio is such that the cost of debt exceeds the cost of equity. E) debt-equity ratio results in the lowest possible weighted average cost of capital. 2. M&M Proposition I with tax implies that the: A) weighted average cost of capital decreases as the debt-equity ratio increases. B) value of a company is inversely related to the amount of leverage used by that company. C) value of an unlevered company equals the value of a levered company plus the value of the interest tax shield. D) cost of capital is the same regardless of the mix of debt and equity used. E) cost of equity increases as the debt-equity ratio decreases.

Answer 1

Optimal Capital structure can be achieved when a perfect mix of debt and equity financing happens to minimize the cost of capital of weighted portfolio. In short when the Weighted Average Cost of Capital is minimized.

Option A: Debt to Equity is 1: Not right because here WACC is not minimized as per the funding cost of Debt and Equity.

Option B: It is the same option as Option A -Debt Equity is 1 here also. Not right

Option C: Cost of Equity is maximized given a pretax cost of debt: Not Right instead of Managing the complete portfolio managing only cost of Equity is not right.

Option D: Debt-equity ratio is such that the cost of debt exceeds the cost of equity. Not Right Maximizing cost of debt as compared to cost of equity never ensure the optimimal capital structure.

Option E : Debt-equity ratio selected results in the lowest possible weighed average cost of capital. Right Answer Because the optimal cost of capital will be achieved when WACC is minimized

Answer : E : Debt-equity ratio selected results in the lowest possible weighed average cost of capital.