Question

"If a negative EFN (External Financing Needed, aka AFN) is lessening the firms debt because of the ability to pay off existing debt, then it is also reducing the cost of capital."

The above statement is considered to be incorrect because it doesn't make sense that paying off the cheapest form of capital lowers the cost of capital. Can someone correct this?

Answer 1

The correct statement should be :

"If a negative EFN (External Financing Needed, aka AFN) is lessening the firms debt because of the ability to pay off existing debt, then it does not always reduce the cost of capital."

It is because, existing debt may be or may not be costlier than external finance.

If the external debt is costlier than existing debt then this will reduce the cost of capital. However, if the external debt is cheaper than the existing debt then cost of capital will increase.No effect on cost of capital if cost of external debt= cost of existing debt.