Question

5. Why can't a firm's manager infinitely use debt financing? Use your own words to explain it from the perspective of cost of capital.

no example requires

Answer 1

Debt capital refers to the long term and short term loans. These loans come at some interest rate. These interest rates must be paid on regular basis to the lenders. Higher the amount of debt, more is the amount of interest they need to pay to the lenders.

Firms which does not have a very good financial position, find it very difficult to get debt. These debts are then issued by keeping something as collateral . If the firm only has debt, then its most of the assets would be kept as a collateral.

Having only debt in the capital, decreases the solvency of the firm, as the payment to the lenders are given the first priority which increases the amount of risk of repayment. It also create a negative view in the mind of people.

Having only debt will increase the cost the capital. This is because as more and more debt is taken, the credit worthiness of the company decreases. This makes the debt to be available to the company at a higher rate, and keeps on increasing the cost of capital as more and more debt is taken.