Question

Jonkin & Co. is considering an increase it's debt. The firm's current D/A is 0.35 with a WACC of 12.90%. It is considering two possible new levels of debt. Option 1: Issue bonds in an amount that will result in a new D/A of 0.45 with a WACC of 11.00%. Option 2: Issue bonds in an amount that will result in a new D/A of .50 with a WACC of 11.55%. Which will be the optimal? Do not issue any new debt. Maintain the current Capital Structure. Option 1 will result in the optimal Capital Structure among the three options provided. Option 2 will result in the optimal Capital Structure among the three options provided.

Answer 1

THe most imprortant role of the debt is to reduce the cost of capital so that company can take projects will lesser WACC also.

When we increase debt, usually cost of debt used to be less than cost of equity so overall WACC decreases if we take more debt. but when we have huge debt cost of debt increases since risk increases.

in Option-1 as debt/asset increases WACC is decreasing but in the second option WACC is again increasing. so option 1 will result in optimal capital structure since WACC is minimum.