If Interest Expense Lowers Taxes, Why Does the WACC Not

question 116

Multiple Choice

If interest expense lowers taxes, why does the WACC not decrease indefinitely with the addition of more debt?

• A) The tax shield effect of debt will result in a lower cost of equity.
• B) Increasing debt too much can result in a greater likelihood of firm failure (financial distress).
• C) A firm's common stock price will not be affected by the amount of debt a firm uses.
• D) Too much common equity increases the probability of bankruptcy.

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Definitions:

Common Stock

A form of corporate equity ownership, a type of security that represents ownership in a corporation and entitles the shareholder to vote on corporate matters.

Stockholders' Equity

Signifies the stake of shareholders in a corporation, determined by subtracting total liabilities from total assets.

Preference Rights

A set of privileges or priorities given to shareholders, such as the right to purchase new shares before the general public.

Preferred Stock

A class of ownership in a corporation that has a higher claim on its assets and earnings than common stock, usually with fixed dividends.