Question

Indicate whether you agree or disagree with the statement and provide a short rationale to support your decision.

As a firm increases the percentage of debt financing used, the component cost of equity capital increases. Agree or disagree, and why.

Answer 1

Solution :

A firm can use debt, equity or preference share financing. When a firm increases the percentage of debt so effectively Debt/equity ratio increases. The firm becomes riskier in the eyes of an investor.  

Using CAPM model we can see the components of cost of equity

Cost of equity = Risk-free rate + Beta * market risk premium

Risk-free rate and market risk premium are independent of financing option of the company but the beta ( Levered ) is dependent upon the D/E ratio.

Beta ( Levered ) = Beta (Unlevered) * [ 1 +D/E * (1-Tax)]

As debt financing increases, D/E increases and due to this Beta levered will increase. This increase in beta value will lead to higher cost of equity

So based on this we can say that increase in debt percentage will increase the cost of equity