As a firm increases its use of debt financing, what is the impact upon the cost of equity?
A)The cost of equity decreases.
B)The cost of equity remains the same.
C)The cost of equity increases.
D)None of the above.

Question

Quizplus · Accepted Answer

As a firm increases its use of debt financing, the risk for equity holders also increases. This is because debt holders have a legal claim on the company's assets and cash flows, which reduces the amount of money available for equity holders. As the risk to equity holders increases, they will demand a higher return on their investment, leading to an increase in the cost of equity. Therefore, the correct answer is option C - the cost of equity increases.

As a Firm Increases Its Use of Debt Financing, What