An implicit cost of increasing the proportion of debt in a firm's capital structure is that:

Question

Quizplus · Accepted Answer

Increasing the proportion of debt in a firm's capital structure increases the risk for equity holders since they become more exposed to the firm's financial leverage. To compensate for this added risk, equity holders will demand a higher rate of return, which increases the cost of equity. This is known as the "cost of financial distress" or "financial risk." Consequently, firms may choose to maintain a balanced capital structure to minimize the negative impact on their overall cost of capital.

An Implicit Cost of Increasing the Proportion of Debt in a Firm's