Question

A firm calculates its cost of debt and finds it to be 9.75%. It then calculates its cost of equity capital and finds it to be 16.25%. The firm’s chairman tells the chief financial officer that the firm should issue debt because it is cheaper than equity. How should the chief financial offi- cer respond to the chairman? (You may assume that the chief financial officer’s job is secure!)

The cost of debt is always less than the cost of equity because of the risk-return tradeoff

The Chairman is right

the chairman is wrong

it is always better to issue debt

A and B

A and C

A and D

B and C

B and D

C and D

All But A

All but B

All but C

All but D

all are true

Answer 1

I can say that first three options A,B,C are correct.

The cost of debt is always less than the cost of equity because of the risk-return tradeoff-

Genarally cost of debt less than cost of equity because risk for debt holders is less and risk for equity holders is high. so we can say that staement A is always True.

we can say Chairman is partially right and partially wrong.

chairman right in saying cost of debt is low. but chairman is wrong in saying we have to invest in debt because cost of debt is low.

in investing we have consider risk factor also. chairman ignored the risk factor.

By totally investing in debt Required return for equity increases because they have to bare more risk.

Company have to decide debt equity ratio based on their leverage capacity.

Ideal debt to equity ratio is 2:1.

So i can say all three except D is correct.