Question

Explain how 'cost of debt' affects the choice of capital structure of a company

How does ‘Cost of Debt’ affect the capital structure of a company? State.

Answer 1

Cost of debt affects the choice of capital structure of a company. If the firm can borrow funds at a lower rate (i.e. low cost of debt), then more debt can be raised. On the contrary, if the firm can borrow funds at a higher rate (i.e. high cost of debt), then a lesser amount of a debt will be raised

Low cost of debt ⇒ Higher Proportion of Debt in Capital Structure

High Cost of Debt ⇒ Lower Proportion of Debt in Capital Structure

Answer 2

Debt is risky where payment of regular interest on the debt is a legal obligation of the business. If the firm can manage a borrowed fund at a lower rate of interest, then it will prefer to have more of debt as compared to equity.