If a firm chose to increase its debt ratio from 20% to 40%, what is the potential risk?
A) The average cost of capital would most likely rise.
B) The price of the firm's common stock would definitely decline.
C) If economic forces cause a reduction of sales, the firm's EPS might decline.
D) The firm's WACC might decline.

Question

Quizplus · Accepted Answer

Increasing the debt ratio increases the financial leverage of the firm, making the firm more vulnerable to economic downturns. If sales decline, the interest expense on the increased debt will still need to be paid, potentially causing a decline in earnings per share (EPS). The other choices are not necessarily true - the average cost of capital and WACC may or may not rise or decline depending on factors such as the interest rate environment, and the price of the firm's common stock may or may not decline depending on investor perception of the increased debt.

If a Firm Chose to Increase Its Debt Ratio from 20