As debt is substituted for equity in the capital structure and the debt ratio increases, all of the following statements about the component costs of capital are true EXCEPT
A) the cost of equity continually increases.
B) the cost of debt continually increases.
C) the overall cost of capital first declines, reaches a minimum, and then rises again.
D) the overall cost of capital continually increases.

Question

Quizplus · Accepted Answer

The overall cost of capital does not continually increase; it first declines as debt is cheaper than equity, reaches a minimum, and then rises as the risk of financial distress increases with more debt.

As Debt Is Substituted for Equity in the Capital Structure