As more debt is added to the capital structure of a firm, the cost of debt capital
A)initially rises slowly, then falls beyond some point
B)increases at a steady rate throughout the entire range
C)beyond some point, becomes greater than the cost of equity
D)initially rises slowly, then increases rapidly beyond some point

Question

Quizplus · Accepted Answer

As more debt is added to the capital structure of a firm, the risk of default increases for lenders leading to an increase in the cost of debt capital. Initially, the increase may be slow as the debt levels are low and the risk of default is low. However, beyond a certain point, the risk of default increases rapidly, causing lenders to demand higher interest rates, leading to a rapid increase in the cost of debt capital. This creates a tipping point where the cost of debt capital becomes greater than the cost of equity, making it less attractive for the firm to raise further debt capital.

As More Debt Is Added to the Capital Structure of a Firm