1. According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on “reasonable” terms. This occurs because the use of debt financing signals to investors that the firm’s managers think that the future does not look good.
a. True
b. False
2. Which of the following statements is CORRECT?
a. Since debt financing raises the firm’s financial risk, increasing the target debt ratio will always increase the WACC.
b. Since debt financing is cheaper than equity financing, raising a company’s debt ratio will always reduce its WACC.
c. Increasing a company’s debt ratio will typically reduce the marginal costs of both debt and equity financing. However this action still may raise the company’s WACC.
d. Increasing a company’s debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company’s WACC.
e. Since a firm’s beta coefficient is not affected by is use of financial leverage, leverage does not affect the cost of equity.