Question

Please compare. What is the tradeoff between taking on a lot of debt due to its low cost versus an increased probability of financial distress when too much debt is used. How does this relate to an optimal capital structure? Give an example that related to the question.

Answer 1

Answer: Cost of debt is less expensive than equity as it is less risky. Reason being that Debt investors have priority over equity investors in terms of payments and in case of liquidation as well of the Company.

Keeping less expensive thing aside of debt, taking too much debt could create issue of bankruptcy for the Company as you have to pay fixed interest payments at regular intervals and If somehow your company cash flow dwindles, it creates the issue of bankruptcy. This increased risk forces the investors to demand higher returns, which in turn increases the WACC and lowers the market value of the Company. So finding the optimal funding through debt and equity becomes very important for a company so risk of bankruptcy does not increase is known as the optimal capital structure.

example 99 cents store, which has unstable capital structure and has been downgraded by credit rating agencies because of it. Creditriskmonitor gave it a bankruptcy chances of 50%