Question

If the cost of debt is the lowest among the sources of financing, would increasing the percentage of debt in the Capital Structure reduce the Cost of Capital to the firm?

The ratio of Equity to Total Assets is very low in Banks. Why is that the case?

Answer 1

Yes with the increase in debt amount the cost of capital decreases as it is the weighted average sum of equity cost and post-tax debt cost. Hence the increase in debt amount increses the weight of cost of debt as well as cost of debt is comparatively lesser than costof equity.

A bank is a financial intermediary where it accepts deposits and lends money. So it gains a profit margin from the interest rate spread. Hence it only deals with cash and the nature of business is acting as a counterparty to the depositors and lenders.

So the business doesn't need much capital infusion which results in the ratio of Equity to Total Assets is very low.