Beginning with a zero-leverage company, as debt is substituted for equity in the capital structure ________.
A) the overall cost of capital first rises, reaches a maximum, and then declines
B) the overall cost of capital declines
C) the overall cost of capital first declines, reaches a minimum, and then rises
D) the overall cost of capital rises

Question

Quizplus · Accepted Answer

When a zero-leverage company substitutes debt for equity in its capital structure, the overall cost of capital first declines due to the tax-deductibility of interest payments. However, as the company takes on more debt, the risk to equity holders increases, causing them to require a higher return, thereby increasing the overall cost of capital. At some point, the cost of debt and the increased cost of equity will outweigh the tax benefits of debt, and the overall cost of capital will begin to rise. Thus, the overall cost of capital first declines, reaches a minimum, and then rises.

Beginning with a Zero-Leverage Company, as Debt Is Substituted for Equity