Which of the following is a true statement?
A) A firm's cost of debt increases with the use of equity in the capital structure.
B) A firm's cost of equity increases with the use of equity in the capital structure.
C) A firm's cost of equity increases with the use of debt in the capital structure.
D) A firm's cost of equity decreases with the use of debt in the capital structure.

Question

Quizplus · Accepted Answer

A firm's cost of equity increases with the use of debt in the capital structure because as a firm takes on more debt, the risk to equity holders increases since debt holders have priority over equity holders in the case of liquidation. This increased risk leads to a higher required return by equity investors, thus increasing the cost of equity.

Which of the Following Is a True Statement