Question

The XYZ company currently has a debt-to-equity ratio of 20%. Assume no taxes and perfect contracting.

1:If the XYZ company decides to increase their debt-to-equity ratio to 40%, what will happen to their cost of equity?

A:The cost of equity will stay the same

B:The cost of equity will go down

C:The cost of equity will go up

2:If the XYZ company decides to increase their debt-to-equity ratio to 40%, what will happen to their total cost of capital?

A:The total cost of capital will go down

B:The total cost of capital will go up

C:The total cost of capital will stay the same

Answer 1

Q1) Cost of equity is not affected by the structure of capital. Therefore, if the debt to equity ratio goes up to 40, the cost of equity will stay the same.

Hence, Option A is the answer.

Q2) We know that the cost of equity is the most expensive source of capital and if there is a change in the structure of capital and the debt component increases, eventually the equity component will reduce. So, the cost of the capital will decrease.

Hence, Option A is the asnwer.