Question

Subject : Corporate Finance Theory

Please provide me answers with details that is based on the corporate finance theories

Suppose that a firm increases its leverage ratio in a frictionless and complete financial market. Discuss whether and how its cost of equity would change. You must provide the reason.

Answer 1

When a firm will increase its leverage ratio in a complete financial market, its cost of equity will be change depending upon various factors in different scenarios-

A. When the overall rate of return on capital of the company is higher than cost of the capital and the cost of the debt of the company then the addition of the debt capital will be increasing in the growth of the company and it will be resulting into decrease into the overall cost of equity

B.when the overall rate of return on the capital of company is lower than the cost of the capital of the company, and in such cases the debt of the company will be a burden to the company and it will be increasing the overall cost of equity of the company, and it will not be resulting into any growth and in such cases it would not be prudent to add debt capital into the overall capital structure.

it should often be noted that the interest payment which are payable onto the debt financing is always resulting into increase into the tax deduction of the company as interest payable is tax deductible and it will hence lead to a benefits of taxation for the overall company but debt capital also have a cost of financial distress so both has to be equally balanced before deciding upon addition of the debt capital.