Question

Which of the following statements about the corporate cost of capital is most correct?

A	Because the use of debt financing increases a business’s financial risk, increasing the debt ratio will always increase the corporate cost of capital.

B	Because debt financing is less costly than equity financing, increasing the debt ratio will always reduce the corporate cost of capital.

C	Increasing the debt ratio typically will reduce the marginal cost of both debt and equity; however, it still may increase the corporate cost of capital.

D	Statements a. and c. are correct.

E	None of the above statements is correct.

Answer 1

ANSWER

CORRECT ANSWER Option (E) "None of the above statements is correct"

EXPLANATION FOR EACH OPTION :

• Option (A) : INCORRECT because Debt is Considered to be a cheaper Source of Finance that Equity as Equity bears greater degree of risk than the Debt Providers. Also Debt provides a Tax Benefit to the company as the Interest Cost paid on Debt is a "Tax Deductible Expense" hence making Debt a cheaper Source.Therefore its not true that Introducing Debt will always Increase the Corporate Cost of Capital.

• Option (B) : INCORRECT because although Debt being a cheaper source that Equity, but there ain't any hard and fast rule that Debt would always Lower the Corporate Cost of Capital. For Instance it might happen that due to current situation of Company Debt is Availabe at even higher rate than that of Equity.

• Option (C) : INCORRECT because Increasing Debt in the Capital Structure INCREASES the Marginal Cost of both Debt and Equity because Introducing More Debt Increases the Risk Factor in that company. Hence Now both Debt & Equity Expects more due to Additional Risk that is added due to Addition Debt Issue. Hence it will Increases the Marginal Cost of Both BUT it MAY reduce the Overall Corporate Cost of Capital.