Question

Assume perfect capital markets. Since the debt claim is senior to the equity claim, debt is cheaper than equity. Therefore, a simple strategy to reduce the cost of capital would be to take on as much debt as possible. DISCUSS this claim concisely.

Answer 1

In case of perfect capital markets there is no transactions cost and no taxes.

There are two sources of finance as we know debt and equity and debt is cheaper source of finance because of tax deduction of interest payments and non deduction of dividend payment to shareholders.But in case of perfect capital markets there is no such advantage of tax deduction in case of debt.

Debt is a cheaper source of finance so increasing the debt will reduce the WACC but it is not possible everytime because increase in interest payment due to increase in amount of debt increases the volatility of dividend payment to shareholders because interest is required to paid in any situation wheather there is profit or not which efeects the companys ability to pay the dividend subsequently it increases the financial risk to the shareholders and they will require greater return to compensate the increased risk thus cost of equity will increase which increases the WACC of the company.

Thus issuing more debt reduces expensive equity and reduces WACC whereas it increases cost of equity because of greater financial risk.Further there is no tax advantage of Increased debt because of perfect market the reduction in WACC due to increased debt will be completely compensated by increased cost of equity because of greater financial risk which means there will be no impact on the firm cost of capital.