Which of the following is a valid reason for a firm not to use as much...

Which of the following is a valid reason for a firm not to use as much debt as it can raise?

a. All of them are valid reasons for a firm to use less debt than might be available

b. The use of more debt is expected to result in a lower price/earnings ratio

c. More debt will increase the firmʹs riskiness

d. The use of more debt is expected to result in an increase in the firmʹs cost of capital when everything is considered

Expert Solution

The correct answer is (C).

The valid reason for firm to not to use as much debt as it can raise is more debt increase the risk of the firm. The firm has to make interest payment on debt and missing any payment obligation might cause serious damage to credit worthiness of the company.

A) The firm should use appropriate amount of debt where the weightage average cost of capital is least rather than randomly deciding the amount of debt in capital

B) The use of debt does not always result in the lower price to earning ratio, it depends on earnings due to leverage and other factors and change in stock price due to profit and growth potential and other factors.

D) The use of more debt does not necessarily results in the increase in the cost of capital, rather WACC depends on the optimal debt to equity level where the cost of capital (WACC) for the firm is least. Increasing debt beyond optimal debt/equity ratio will increase in the cost of capital but when the debt to equity ratio is less than optimal, adding debt can reduce the overall cost of capital and also enhance the ROE.

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