Which of the following statements is true?

Question

Quizplus · Accepted Answer

When a firm issues debt of equal or greater priority to its existing debt, the value of the firm remains unchanged. However, the cost of debt capital will be higher due to the increased risk for bondholders. Option A is incorrect because the value of the existing bonds will decrease, but not necessarily the value of the equity. Option B is incorrect because the cost of debt capital will be higher, but it does not necessarily decrease the value of the firm. When a firm issues bonds of equal or higher priority to its existing debt, the value of the equity remains unchanged because the firm's assets still back the same total amount of debt. However, the cost of issuing the new debt will be higher due to the increased risk premium associated with higher priority debt. This will increase the firm's cost of debt capital. Therefore, option C is the true statement. Option A is incorrect because it incorrectly implies that the value of both the existing bonds and equity will decrease when only the value of the bonds will decrease. Option B is incorrect because it implies that the value of the firm will decrease due to the higher cost of debt capital, when in fact the value may remain unchanged. Option D is incorrect because option A is incorrect.

Which of the Following Statements Is True