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If a firm issues debt, shareholders will assume the firm's common stock is Blank undervalued and/but if a firm issues equity, shareholders will assume the firm's common stock is Blank overvalued.
What is the impact on the present value of distress costs as more debt is added?
- Higher debt levels lessen the amount of discretionary financial flows that management controls, which lessens the waste brought on by managerial laziness or perquisite spending.
- Therefore, larger debt levels increase the value of the company.
- The present value of the anticipated costs of financial difficulty reduces the value of the leveraged firm.
Which of the following are generally true about the cost of equity and the cost of debt?
- Leverage increases the cost of debt.
- Leverage has the potential to raise the cost of equity.
- Generally speaking, the cost of debt is less than the cost of equity.
Why is cost of equity higher than cost of debt?
- Although equity does not require repayment, it typically costs more than borrowed capital because interest payments are tax deductible.
- Stock often offers a better rate of return than debt since the cost of equity is higher.
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