Holding all other things equal, as the relative amount of debt in the capital structure of the firm increases, the cost of equity capital will ____.
A) increase
B) decrease
C) remain unchanged; there is no relationship between the two
D) initially rise rapidly, then increase slowly beyond some point

Question

Quizplus · Accepted Answer

As the relative amount of debt in the capital structure of the firm increases, the riskiness of equity increases. This is because debt holders have a prior claim to the firm's assets and cash flows. Therefore, equity holders face a higher risk of the firm being unable to meet its debt obligations, which increases the required rate of return for equity investors. Hence, the cost of equity capital will increase.

Holding All Other Things Equal, as the Relative Amount of Debt