Dibert: What is the relationship between the weighted average cost of capital (WACC) and the cost of equity ( rs)? In this way, Dilbert believes that the firm will be choosing the D/E ratio that maximizes the value of the firm. Do you agree with Dilbert? Why or why not?
Not what you're looking for?
Dilbert has recently taken a course in financial management and has learned the following: The cost of debt, rd, is normally less than the cost of equity, rs. Consider a firm which has no debt. If the firm is an all equity firm (i.e. it has no debt), (1) what is the relationship between the weighted average cost of capital (WACC) and the cost of equity ( rs)?. A diagram may help explain your answer.
Dilbert further recognizes that there are costs associated with debt. For example, if the firm issues debt (and with the proceeds of the debt, repurchases equity,) it will be adding to its financial distress and agency costs. This means that the there will be (1)an increase in expected value of bankruptcy costs, as well as (2)additional costs due to the restrictions likely to appear in bond covenants and (3) additional costs in monitoring these restrictions in the bond covenants. Consequently, Dilbert reasons that to avoid these, the firm should keep its debt to a minimum. In this way, Dilbert believes that the firm will be choosing the D/E ratio that maximizes the value of the firm.
(2) Do you agree with Dilbert? Why or why not?
Purchase this Solution
Solution Summary
The computations and explanations are given to determine the relationship between the WACC and the cost of equity.
Solution Preview
Please see the attached file.
Dilbert is correct. The trade off model of the capital structure decisions says that a firm has to make a trade off between the benefits of debt and costs of debt. The benefit of tax is ...
Purchase this Solution
Free BrainMass Quizzes
Marketing Management Philosophies Quiz
A test on how well a student understands the basic assumptions of marketers on buyers that will form a basis of their marketing strategies.
Business Processes
This quiz is intended to help business students better understand business processes, including those related to manufacturing and marketing. The questions focus on terms used to describe business processes and marketing activities.
Basics of corporate finance
These questions will test you on your knowledge of finance.
Understanding Management
This quiz will help you understand the dimensions of employee diversity as well as how to manage a culturally diverse workforce.
Operations Management
This quiz tests a student's knowledge about Operations Management