Although the after-tax cost of debt is below the cost of equity, firms cannot increase their use of debt without limit.

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Firms cannot increase their use of debt without limit due to factors such as creditworthiness, lender requirements, and financial risk. As a firm takes on more debt, it becomes riskier and may have trouble obtaining financing if lenders perceive the company to be too highly leveraged. Eventually, the cost of debt may rise to the point where it is no longer beneficial to the firm to issue more debt. Therefore, although the after-tax cost of debt may be lower than the cost of equity, firms must consider their overall financial risk and ability to take on additional debts before increasing their debt levels.

Although the After-Tax Cost of Debt Is Below the Cost