Please help and see if these answers are correct or not.. Biddle Publishing curr

Question

Please help and see if these answers are correct or not..

Biddle Publishing currently is financed with 10% debt and 90% equity. However, Biddle's CFO has proposed that the firm issue new long-term debt and repurchase some of the firm's common stock. Biddle's advisors believe the long-term debt would require a before-tax yield of 10%, while the firm's basic earning power (BEP) is 14%. The firm's operating income and total assets will not be affected. The CFO has told the rest of the management team that he believes this move will increase the firm's stock price. If Biddle proceeds with the recapitalization, which of the following items is also likely to increase? Cost of debt (rd) Return on assets (ROA) Basic earning power (BEP) Cost of equity (rs) Return on equity (ROE) The CFO's proposal has opened up a dialogue among the company's management team about the effects of debt financing. In particular, one manager notes that debt financing is cheaper than equity financing. He suggests that using more debt always will decrease the firm's weighted average cost of capital (WACC). Is this true? No Yes

Explanation / Answer

Part 2 is wrong the answer should be NO. Increasing debt only decreases the WACC to a certain level after that debt can be dangerous. The issue of financial distress comes into play, so financial leverage cannot be used beyond a limit. If the above statement were true then thoretically using a 100% debt wouldd result in the lowest WACC. If this were true every company would have employed only debt!!!

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