As debt is substituted for equity in the capital structure and the debt ratio increases, the behavior of the overall cost of capital is partially explained by ________.
A) the tax-deductibility of interest payments
B) the increase in the number of common shares outstanding
C) the reduction in risk as perceived by the common shareholders
D) the decrease in the cost of equity

Question

Quizplus · Accepted Answer

The tax-deductibility of interest payments reduces the overall cost of capital as it lowers the effective cost of debt. This, in turn, raises the debt ratio, shifting the capital structure towards debt.

As Debt Is Substituted for Equity in the Capital Structure