Question

As debt in a firm’s capital structure is increased from no debt to a significant proportion of debt (say, 60%), what tends to happen to the cost of debt, the cost of equity, and the overall weighted average cost of capital?

Answer 1

Here two cases are possible and explaination is based on modiglani Miller theory

If there is no tax: according to modiglani Miller theory in a tax free world capital structure mix will not have influence of firms wacc

In a tax world : in a tax world interest payments arr tax deductible where as dividends are not tax deductible this reduces cost of debt l. But after tax cost of debt remains same without regard to capital structure where as in case of equity when debt is increased from 0 to 60% equity holders will become risk cautious and cost of equity will increase thus wacc will not vary significantly