Question

As the CFO of Monash Inc., you decrease the proportion of capital financed through debt. Which of the following impacts upon the cost of equity is the most correct?

Select one:

a. None of the above.

b. K_e will increase due to higher risk of residual claim.

c. K_e will increase due to lower risk of residual claim.

d. K_e will decrease due to lower risk of residual claim.

e. K_e will decrease due to higher risk of residual claim.

Answer 1

The answer to the question is d) ke will decrease due to lower risk of residual claim

This is because cost of debt represents a permanent cost to the firm in terms of interest to be paid. It cannot be avoided even in situations of losses. Therefore if there is less debt, the permanent cost will be less and the probability of claims to shareholders will increase and thus their risk will decrease.

Why other options are incorrect?

a, b, and c are incorrect bcause it will not increase and e is incorrect because there will be lower risk.

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