Poutine Cheese Co

question 43

Multiple Choice

Poutine Cheese Co.operates in a world with zero taxes and there is no risk of financial distress.Currently the firm has a D/E ratio of 3.5,a cost of debt of 8 percent,and a cost of equity of 15 percent.Xin,a junior analyst,states that if the firm increases their use of debt their WACC should decrease.Xin is:

• A) Correct because as we increase the use of debt the WACC should decrease as we are increasing our use of a cheaper source of capital (cost of debt < cost of equity).
• B) Correct because according to M&M the value of the firm is unchanged as we increase the level of debt but the net income of the firm will decline (due to increased interest payments). The only way the value of the firm can remain the same is if the WACC decreases.
• C) Incorrect because as we increase the use of debt we increase the riskiness of the equity and therefore the cost of equity will increase. The net effect is that the WACC remains constant.
• D) Incorrect because the firm's D/E ratio is already above the firm's optimal level and any further increase in debt will result in an increase in the WACC and a decrease in firm value.

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Definitions:

Subsidiary

A company that is completely or partly owned and partly or wholly controlled by another company, known as the parent company.

Affiliate

A company that is controlled by a parent company or is closely related to another company through common ownership or control.

Available-for-sale Securities

Financial assets that are not classified as held-to-maturity or trading securities, and can be sold in the short term for liquidity purposes.

Unrealized Loss

A loss that results from holding onto an asset that has decreased in price, but has not yet been sold.