Tropical Fruit Drinks issued $10,000,000 in bonds to expand its production facilities.After issuing the bonds, the company was 60% debt financed and 40% common equity financed.Tropical intends to retire 20% of the bonds each year for the next five years and not to issue any new debt.

Question

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Since Tropical intends to retire 20% of the bonds each year for the next five years and not to issue any new debt, the company's debt-to-equity ratio will gradually decrease over the next five years. As a result, the company's financial risk will decrease and its cost of capital will decrease as well. However, the effect of this decrease will be partially offset by the fact that the company will have smaller interest tax shields each year due to the retiring debt. Therefore, it is expected that the cost of equity will increase gradually over the next five years, which will partially offset the decline in the cost of debt. Overall, we would expect Tropical Fruit Drinks cost of capital to increase gradually over the next five years.

Tropical Fruit Drinks Issued $10,000,000 in Bonds to Expand Its