Question

The Chief Financial Officer at BBB Ltd., notes that the company’s cost of debt is below its cost of equity. They reason that the company should ensure that it is able to increase its borrowings, because otherwise it will be forced to use more expensive equity to finance its new projects. If it used equity then, the company might have to reject some projects that it would have accepted when evaluated at the lower cost of debt. Comment on this reasoning.

Answer 1

As mentioned in the statement, cost of equity is higher than cost of debt. Hence if we take more equity instead of debt, the company's cost of capital or wacc which includes weighted average of both equity and debt will be higher. Due to this many projects viability which is checked through NPV valuation will become negative( higher wacc or discount rate more chance of a project cashflow to become negative). So this statement of CFO regarding rejection of project is correct.

However we should also try to make an optimal structure instead of borrowing too much debt. If the debt/asset ratio is higher than company's ability to repay it, it will cause higher risk to the company and profitability will be significantly reduced due to interest expenses. There should always be a balance between these two type of financing.