Question

As the amount of a debt a firm uses increases,

Group of answer choices

the costs of both debt and equity increase, but the weighted average cost of capital for the firm remains unchanged

the expected return on debt increases, but its promised return remains the same

the cost of debt increases, but the cost of equity remains unchanged                                                    

the costs of both debt and equity increase, which will cause the weighted average cost of capital for the firm to increase

Answer 1

the costs of both debt and equity increase, which will cause the weighted average cost of capital for the firm to increase

Due to the use of higher debt, the firm becomes more risky. This increases its cost of both debt and equity resulting in greater WACC. Option 1 and 3 are hence incorrect since both debtholders and shareholders demand greater returns. Option 2 is incorrect since the promised return has to increase with greater risk.