If a firm increases the proportion of debt in the capital structure:A.The cost of debt will increase but there will be no impact on the cost of equity.B.The cost of equity and the cost of debt will both increase, but its cost of capital will fall.C.The cost of equity will increase, but the impact on the firm’s cost of capital is unclear in the absence of specific information about financial distress costs and the firm’s tax position.D.The cost of equity will increase but the cost of debt will decrease.
Question
If a firm increases the proportion of debt in the capital structure:A.The cost of debt will increase but there will be no impact on the cost of equity.B.The cost of equity and the cost of debt will both increase, but its cost of capital will fall.C.The cost of equity will increase, but the impact on the firm’s cost of capital is unclear in the absence of specific information about financial distress costs and the firm’s tax position.D.The cost of equity will increase but the cost of debt will decrease.
Solution
The correct answer is C. "The cost of equity will increase, but the impact on the firm’s cost of capital is unclear in the absence of specific information about financial distress costs and the firm’s tax position."
When a firm increases the proportion of debt in its capital structure, it increases the financial risk for equity holders. This is because equity holders are residual claimants and are paid after debt holders. Therefore, they require a higher return for the increased risk, which increases the cost of equity.
However, the impact on the firm's overall cost of capital (which is a weighted average of the cost of debt and the cost of equity) is unclear without specific information about the costs of financial distress (which increase with more debt) and the firm's tax position (since interest on debt is tax-deductible, which can decrease the effective cost of debt).
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