Question

. Show how a firm can increase its cost of equity and cost of debt capital, yet still come out with an overall cost of capital that is unchang

Answer 1

Yes, it is possible that cost of equity increases but overall cost of capital remains unchanged. In same manner it is also possible that if cost of debt increases but overall cost of capital remains unchanged. Let’s wee how it is possible;

As per M&M proposition, change in cost of equity or change in cost of debt will not affect overall cost of capital because low cost benefits of one source of capital is offset by the increasing cost of other source. Soppose a company raise additional capital through equity then cost of equity will increase due to higher demand of their investment but on other hand cost of debts decreases in same manner thus overall cost of capital will not change. On other hand if a company raise capital through debt due to low interest rates then expectations of the equity will increase due to higher risk that is why low cost benefits of debts will be offset by the higher expectations of shareholders. As company raise more & more debt funds then expectations of the debts providers will increase due to higher demand of their funds but expectations of shareholders will decrease due to low demand of their funds hence increased cost of debts wil be offset by the low cost of equity thus overall cost of capital will remain unchanged.

Thus it proves that increasing cost of equity or increasing cost of debts will not change overall cost of capital.