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Answer to Question #6762 in Economics of Enterprise for LaMarcus Streeter

Question #6762
2. Which of the following statements is CORRECT?

a. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt.
b. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price.
c. The capital structure that minimizes the firm’s weighted average cost of capital is also the capital structure that maximizes its earnings per share.
d. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.
e. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted tradeoff theory would suggest that firms should increase their use of debt.
Expert's answer
Statement B is CORRECT. The firm’s optimal capital structure is simply defined as the mix of debt, preferred stock and common equity that will optimize the company's stock price. As a company raises new capital it will
focus on maintaining this optimal capital structure. Thus, the capital structure will optimize the company's stock price and minimize the
company's weighted-average cost of capital (WACC). Both methods yield the same
results.

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