Case Scenario:
Dilbert has recently taken a course in financial management and has learned the following: The cost of debt, rd, is normally less than the cost of equity, rs. Consider a firm which has no debt. If the firm is an all equity firm (i.e. it has no debt),
(1) what is the relationship between the weighted average cost of capital (WACC) and the cost of equity (rs)?. A diagram may help explain your answer.
Dilbert further recognizes that there are costs associated with debt. For example, if the firm issues debt (and with the proceeds of the debt, repurchases equity,) it will be adding to its financial distress and agency costs. This means that the there will be (1)an increase in expected value of bankruptcy costs, as well as (2)additional costs due to the restrictions likely to appear in bond covenants and (3) additional costs in monitoring these restrictions in the bond covenants. Consequently, Dilbert reasons that to avoid these, the firm should keep its debt to a minimum. In this way, Dilbert believes that the firm will be choosing the D/E ratio that maximizes the value of the firm.
(2) Do you agree with Dilbert? Why or why not?