Question

true and false

. The cost of equity is expected to be higher than the after-tax cost of debt. Therefore, increasing the debt ratio will always lower the cost of capital.

2. Firms with more uncertainty about future investment needs (both in terms of magnitude and type) should generally borrow more money than firms with less uncertainty
3. Debt is cheaper source of financing than Equity. Explain the potential reasons this may be true or false

Answer 1

The cost of equity is expected to be higher than the after-tax cost of debt. Therefore, increasing the debt ratio will always lower the cost of capital. True

Explanation:

Cost of equity is generally higher than after tax cost of debt because equity investors will never invest in case return on investment is lower than cost of debt because equity holders are subordinate of debt holders.

Firms with more uncertainty about future investment needs (both in terms of magnitude and type) should generally borrow more money than firms with less uncertainty. False

Explanation:

Borrowing more than required leads to improper utilization of funds and also affects the bottom line of the company's P&L statement.

Debt is cheaper source of financing than Equity True

Explanation:

Debt is a cheaper source of financing due of couple of reasons:

• Tax Benefit
• Limited Obligation to lender
• Limited upside risk to company