New Heritage Doll Co. is considering opening five new retail stores in East Coast that would require external financing. Amy Chen, the CFO of New Heritage announced in a board meeting thatthe management is planning to increase the proportion of debt in the company's capital structure.

CelestilaMoonnis one of the senior managers at the corporate finance department of New Heritage gathered the following market data for her analysis to identify the capital structure that maximizes the firm's stock price and minimizes the weighted average cost of capital.

In response to a question regarding capital structure theory,Moonnmade the following statement:

The deductibility of interest lowers the cost of debt and the cost of capital for the company as a whole. Adding the tax shield provided by debt to the Modigliani and Miller framework suggests that the optimal capital structure is all debt.

Table 1

Marketvalue of debt : $100milion

Yieldto maturity on debt : 8.0%

Marketprice per share of common stock : $30

Numberof shares of common stock : 10milion

Costof capital if all equity-financed : 10.3%

Marginaltax rate : 35%

Table2

Debt-to-TotalCapital Ratio% Cost of Equity % Cost of debt %

20 7.7 12.5

30 8.4 13.0

40 9.3 14.0

50 10.4 16.0

1.According to the pecking order theory,New Heritage'sannounced capital structure change:

A. Is optimal because debt is cheaper than equity on an after-tax basis.

B. May be optimal if new debt is issued after internally generated funds are made complete use of as a source of capital.

C. May be optimal if new debt is issued after new equity is made complete use of as a source of capital.