It is not uncommon to hear people say that because debt has a lower cost of...

It is not uncommon to hear people say that because debt has a lower cost of capital than equity, a firm can reduce its overall WACC by increasing the amount of debt financing. If this strategy works, shouldn’t a firm take on as much debt as possible, at least as long as the debt is not risky? Explain your answer using M&M Proposition II

Expert Solution

Here we disregard the financial distress or bankruptcy costs and the cost of debt rising, as the debt is not risky. Using MM Proposition II we know that, as debt increases the cost of equity rises because equity becomes more risky. Increasing debt means the required cash flows to service debt will be higher and there might be lower chance to serve those higher cash flows. Equity is residual claimants, i.e., get cash flows only after debt has been repaid. Hence, there is high chance that equity is not paid anything. Therefore, to account for this, equity investors demand higher return. This is what MM Proposition II states. So, if debt is increased, cost of equity might increase as well and thus WACC might increase also.

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