Suppose that a new government is elected and it changes the law applying to firms to: • Allow dividend payments to be tax deductible • Stop interest expense on debt from being tax deductible Holding other factors constant, and assuming that firms seek to maintain an optimal capital structure in accordance with trade-off theory, what would you expect to happen to the debt ratio of a firm with both equity and debt in its capital structure? a. An increase in the debt ratio b. A decrease in the debt ratio c. The debt ratio would be unchanged d. The debt ratio would double e. None of the above or it is not possible to say
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Suppose that a new government is elected and it changes the law applying to firms to:
• Allow dividend payments to be tax deductible
• Stop interest expense on debt from being tax deductible
Holding other factors constant, and assuming that firms seek to maintain an optimal capital
structure in accordance with trade-off theory, what would you expect to happen to the debt
ratio of a firm with both equity and debt in its capital structure?
a. An increase in the debt ratio
b. A decrease in the debt ratio
c. The debt ratio would be unchanged
d. The debt ratio would double
e. None of the above or it is not possible to say
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