Question

Which of the following is not a cost to the firm of increasing debt financing?

Group of answer choices

Investors will demand a higher interest rate on debt.

The risk to common stockholders will increase.

Stockholders will demand a higher return.

The cost of common equity will decrease.

Answer 1

Solution:-

Option 1

As the leverage (debt) of a firm goes up, its debt to equity ratio also goes up which means that financing risk of the company is going up. In this case, as the debt investors see financing risk going up, they realise that the risk of their debt investment (i.e. default risk) has increased and hence they demand a higher rate of interest on their investment.

Hence, this is a cost to the firm for increasing debt financing and therefore, this option is not correct.

Option 2

As the leverage (debt) of a firm goes up, its debt to equity ratio also goes up which means that financing risk of the company is going up and it increases the risk for equity investors. For example: The company will have to pay interest out of its operating cash flows every year irrespective of the fact if the company faces losses or low operating margins and this may result in nothing left out of profits for equity shareholders. This increases the risk for equity stockholders in terms of the impact on EPS.

Hence, the risk for equity shareholders goes up and this is a cost to the firm for increasing debt financing and therefore, this option is not correct.

Option 3

We know that higher the risk higher the required rate of return. As discussed above, the risk for equity shareholders goes up with increase in debt financing due to which they expect higher returns on their share investments as reward.

Hence, this is a cost to the firm for increasing debt financing and therefore, this option is not correct.

Option 4

As discussed above, the expected rate of returns for equity shareholders goes up with increase in debt financing. Therefore, the cost of common equity for the company increases with increase in debt (as shareholders want higher returns on their money).

Hence, the cost of common equity doesn't decrease with increase in debt financing and this is not a cost to the firm and therefore, this option is correct.