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You are working for a public company in the Biotech industry. Your boss comes into your...

You are working for a public company in the Biotech industry. Your boss comes into your office and makes the following statement “Debt is cheap – the interest rate we would pay is only 4%, so we should borrow as much as we can to lower our WACC and increase the value of the firm.” How do you respond to your boss?

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Answer #1

Debt is cheap and certainly lowers the WACC and increase the value of the firm. But, we should not borrow as much as we can. We should only borrow to an extent beyond which the firm value decreases.

Too much debt is risky and it increases bankruptcy costs. If we start to increase the debt from 0%, the value of the firm increases in the beginning but at certain value of debt the firm value peaks out. If we continue to increase debt beyond this point, the adverse costs of debt outweighs the benefits and the firm value starts to decrease.

Therefore, we should only increase debt to a point where our WACC is minimum and the firm value is maximum.

Can you please upvote? Thank You :-)

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