Which of the following statements is most correct?
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A. B. C. D. E.Explanation
Increases in the debt ratio increase the cost of both debt and equity. Bondholders recognize that firms with higher debt levels are more likely to experience financial problems, which will explain why increases in the debt ratio raise the cost of debt. Concerning the cost of equity, the business risk premium, in the required rate of return equation, does not depend on the debt level. It will remain constant at all debt levels. However, the financial risk premium does vary depending on the debt level; the higher the debt level, the greater the risk premium, and therefore the higher the cost of equity.