In the traditional approach to capital structure, as the amount of debt increases in a firm's capital structure, ________.
A) the cost of equity rises faster than the cost of debt
B) the cost of debt rises faster than the cost of equity
C) debt becomes less risky
D) equity cost is unaffected

Question

Quizplus · Accepted Answer

The traditional approach to capital structure suggests that as a firm increases its leverage (amount of debt), the cost of equity increases because equity holders demand a higher return for the increased risk associated with higher debt levels. This is because with more debt, the firm has higher fixed obligations (interest payments), making the equity riskier as debt holders have priority over equity holders in case of liquidation.

In the Traditional Approach to Capital Structure, as the Amount