Question

What generally happens to the cost of debt, cost of equity, and cost of capital when a firm increases Debt and holds Equity constant?

Answer 1

A firm's cost of capital is the weighted average of the cost of equity and cost of debt. Here, the weights are based on the proportion of equity and debt in the capital structure. Generally, the cost of debt is lower than the cost of equity.

As the proportion of debt in the capital structure increases, the risk-ness of the firm increases as higher debt is associated with higher financing and interest costs, which results in a subsequent decline in net profits. As the earnings decrease, shareholders return decreases.

As the debt the leverage increases, the chances of the firm being comfortably able to service its debt decreases as the debt to service ratio decreases. In short, the operating profits to interest costs decrease. All these factors increase the riskiness of the firm.

Impact of the firm increasing Debt and holding  Equity constant

On the cost of equity - The cost of equity increases. This is because as debt increases the riskiness of the firm, equity shareholders demand a higher rate of return to compensate for the higher risk associated with higher debt.

On cost of debt - The cost of debt increases as a firm takes on more debt. This is because as debt increases, the riskiness of the firm increases. New lenders demand a higher rate of return, as the firm is more leveraged now and hence, the ability of the firm to service its debt lowers. Due to this, the overall cost of debt goes up

On cost of capital - Generally, the cost of debt is lower than the cost of equity. Hence, it would seem that the cost of capital would decrease. However, even though the proportion of equity has remained constant, it cost ie. the cost of equity increases due to the increased riskiness. Due to this, the overall cost of capital increases.