Which one of the following is false? a. In a world where interest expense is not

Question

Which one of the following is false?

a. In a world where interest expense is not tax deductible, a firm’s capital structure is irrelevant meaning that WAAC is constant for all levels of E/E.

b. The WAAC always reflects the required return on a firm’s assets regardless of whether or not interest expense is tax deductible.

c. If interest expense is tax deductible, a new asset is created that equals the present value of the interest tax shield. This new asset is a wealth transfer from the Federal government (IRS) to the company’s shareholders.

d. In a world where interest expense is tax deductible and bankruptcy costs are high, there is an optimal capital structure that maximizes the value of the firm. This occurs when the increase in the interest tax shield is offset by higher expected bankruptcy costs.

e. When using the beta of a comparable “pure play” firm to find the cost of capital of a privately held company, one only needs to consider the business risk. Adjusting for the financial risk of the comparable firm is not relevant when using its beta.

Explanation / Answer

Solution:- b. The WAAC always reflects the required return on a firm’s assets regardless of whether or not interest expense is tax deductible.

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