As financial leverage increases, the cost of debt initially remains constant and then rises, while the cost of equity always rises.

Question

Quizplus · Accepted Answer

This statement is generally true. As a company increases its financial leverage by taking on more debt, the cost of debt initially remains constant because the lender assumes less risk due to the increasing value of assets backing the loan. However, as the amount of debt increases, the risk to the lender also increases, resulting in a higher cost of debt. On the other hand, as financial leverage increases, the cost of equity (i.e., the return required by shareholders) always rises because of the increased risk to shareholders.

As Financial Leverage Increases, the Cost of Debt Initially Remains