Question

3) The tax deductibility of interest payments lowers the after-tax cost of debt in the firm’s capital structure. If adding debt to the capital structure lowers the firm’s WACC why do firms not seek to have 100% debt in their capital structure?

Answer 1

Debts are cheaper than equity. The financial capital that company raises consist of both debt and equity. The total cost of capital is the mixture of all sources and is called Weighted Average Cost of Capital.

There is an advantage of raising capital through debt as you get tax benefit.

There has to be a balance in how much capital you want to raise via debt. There is no fixed interest charged for equity capital but in debt capital, the company will have to pay interest even if they are not earning profit. This increases the risk of bankruptcy. There are many covenants that the company needs to sign before raising capital through debts. At times the covenants restrict the smooth flow of operations for the company. As the interest payment is fixed, so earnings volatility is observed. Too much interest payment can lead to negative earnings.