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% ordinary equity financed.Tropical intends to retire 20% of the bonds each year for the next 5 years and not to issue any new debt.

Question

Quizplus · Accepted Answer

As Tropical Fruit Drinks retires 20% of the bonds each year for the next 5 years, its debt-to-equity ratio will gradually decrease, making it less risky and therefore lowering its cost of equity. However, the decreasing debt will also result in a lower amount of interest expenses, which will lower the tax shield from debt and increase the cost of equity. Therefore, the two effects will result in a gradual increase in Tropical Fruit Drinks' cost of capital over the next 5 years, assuming all other things remain equal.

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