- December 3, 2021 at 12:29 pm #642385humaiParticipant
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Sir if company increases level of debt then we know that financial risk increases. This lead to increase in cost of equity. However WACC falls due to higher proportion of debt in capital structure with debt having lower cost than equity and also being tax deductible
But in this case as financial risk increases then cost of debt would also have increased na? OR would it have been reduced?December 3, 2021 at 3:08 pm #642407John MoffatKeymaster
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Your first paragraph is correct (at least in theory, according to Modigliani and Miller).
As far as the cost of debt is concerned, then according to M&M is should remain constant except at very high levels of gearing (because at normal levels it is, in theory, risk free because of receiving fixed interest. It is only at very high levels of gearing the debt becomes more risky because there is more risk of the company not being able to pay the interest).
When we talk about financial risk we are only referring to the extra risk to the equity that is created by higher levels of gearing.
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