As debt is substituted for equity in the capital structure and the debt ratio increases, the behavior of the overall cost of capital is partially explained by
A) the reduction in risk as perceived by the common shareholders.
B) the tax-deductibility of interest payments.
C) the increase in the number of common shares outstanding.
D) the decrease in the cost of equity.

Question

Quizplus · Accepted Answer

Increasing the debt ratio means that the company is relying more on debt financing as opposed to equity financing. This in turn increases the tax-deductibility of interest payments, which reduces the overall cost of capital for the company.

As Debt Is Substituted for Equity in the Capital Structure