If a company increases the proportion of debt in a firm's capital structure, then:
A)the increased debt is not covered by the tax shield.
B)holders of common shares will expect a higher rate of return
C)the company's equity beta will decrease
D)the firm's WACC remains unchanged.

Question

Quizplus · Accepted Answer

When a company increases the proportion of debt in its capital structure, the risk for equity holders increases, as they are last in line to receive payments in case of bankruptcy. Thus, equity holders will demand a higher rate of return to compensate for the increased risk, resulting in an increase in the company's cost of equity. As a result, the firm's weighted average cost of capital (WACC) will increase, since the cost of equity is a component of WACC. Option A is incorrect because the tax shield of debt is recognized when calculating WACC. Option C is incorrect because the equity beta typically increases when debt is added to the capital structure, as debt is a cheaper source of financing than equity. Option D is incorrect because WACC will increase.

If a Company Increases the Proportion of Debt in a Firm's