As the debt level rises, the cost of equity increases because:
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A. B. C. D.B
All of the above are reasons why the cost of equity increases as the debt level rises.
As the debt level rises, the cost of equity increases due to several reasons. Let's examine each answer choice and its relationship to the cost of equity:
A. The probability of default increases: When a company takes on more debt, its risk of defaulting on its debt obligations also increases. Creditors have a higher priority claim on the company's assets compared to equity holders. Therefore, as the probability of default increases, equity holders face a higher risk of losing their investment, which in turn raises the required return (cost of equity) they demand to compensate for the increased risk.
C. The variability of EPS increases: When a company has a higher level of debt, it typically has fixed interest payments to make regardless of its earnings. This fixed interest obligation creates financial leverage, which amplifies the variability of earnings per share (EPS). In other words, as the company's earnings fluctuate, the impact on EPS is magnified due to the fixed interest expense. The increased variability of EPS introduces greater uncertainty for equity investors, leading them to demand a higher return (cost of equity) to compensate for the added risk.
D. The financial risk increases: Financial risk refers to the risk associated with a company's financial structure, particularly its use of debt. When a company takes on more debt, its financial risk increases. This is because higher levels of debt increase the company's interest expense and can lead to higher fixed obligations. If the company's earnings decline or it faces financial distress, it may struggle to meet its debt obligations, which can negatively impact equity holders. As the financial risk increases, equity investors require a higher return (cost of equity) to compensate for the heightened risk they bear.
Based on the above analysis, we can conclude that answer choice B, "all of these answers," is correct. As the debt level rises, all of these factors interact to increase the cost of equity. The probability of default, the increased variability of EPS, and the higher financial risk all contribute to the higher required return demanded by equity investors.