S1. Although the exact relationship between a firm's degree of financial leverage and its beta is difficult to estimate, it has been shown both theoretically and empirically that a firm's beta increases with its degree of financial leverage. S2. As the debt ratio rises, the WACC is reduced because the after-tax cost of debt is usually lower than the cost of equity. What limits the substitution of debt for equity in the capital structure is that as the debt ratio rises the costs of both components eventually increase. Both statements are true Statement 2 is true Statement 1 is true Both statements are false
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.
S1. Although the exact relationship between a firm's degree of financial leverage and its beta is difficult to estimate, it has been shown both theoretically and empirically that a firm's beta increases with its degree of financial leverage.
S2. As the debt ratio rises, the WACC is reduced because the after-tax cost of debt is usually lower than the
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