Chapter 21 Question 3 - Essay Example

Because of this reason the cost of capital starts first to decline to a point where it achieved an optimal mix of debt and equity. If a firm uses too much debt financing, its overall risk profile start to increase. With more debt, the cash flows of the firm started to get strained because of the high proportion of them going for debt servicing. This reduces the free cash flow available to the firm which is one of the essential indicators of the value. It is because of this reason that the required rate of return on equity capital of the firm starts to rise thus increasing the overall cost of capital of the firm.

It is also important to note that with more financing availed; shareholders tend to view the company with more skepticism as high amounts of debts indicate high risk because it may be perceived that the company’s operations may not have the capability to generate cash. Due to this perception, investors, who may be willing to invest into stock of the firm, start demanding high rate of return on equity capital. This, therefore, increases the total cost of