As more debt is added to the capital structure of a firm, the cost of debt capital ____.
A) initially rises slowly, then falls beyond some point
B) increases at a steady rate throughout the entire range
C) becomes greater than the cost of equity beyond a certain point
D) initially rises slowly, then increases rapidly beyond some point

Question

Quizplus · Accepted Answer

As more debt is added to the capital structure of a firm, the cost of debt capital initially rises slowly as lenders are willing to accept a lower interest rate due to the lower risk associated with the additional debt. However, beyond some point, lenders become less willing to loan funds as the risk increases, causing the cost of debt to increase rapidly. This point is known as the firm's optimal capital structure, where the overall cost of capital is minimized. Therefore, D is the best choice.

As More Debt Is Added to the Capital Structure of a Firm