True or false?

a) "As the firm borrows more and debt becomes riskier, both stockholders and bondholders demand higher rates of return. Thus, by reducing the debt ratio we can reduce both the cost of debt and the cost of equity, making everybody better off."

b) "Moderate borrowing doesn't significantly affect the probability of financial distress or bankruptcy. Consequently, moderate borrowing won't increase the expected rate of return demanded by stockholders."

Question

Business

Jolly

23 July, 07:35

True or false?

a) "As the firm borrows more and debt becomes riskier, both stockholders and bondholders demand higher rates of return. Thus, by reducing the debt ratio we can reduce both the cost of debt and the cost of equity, making everybody better off."

b) "Moderate borrowing doesn't significantly affect the probability of financial distress or bankruptcy. Consequently, moderate borrowing won't increase the expected rate of return demanded by stockholders."

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Answers (1)

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Karen Murphy · Answer 1

Both statements are False

Explanation:

Statement a

As with higher debt involved the expected return on investment is more on equity. But reducing debt up till a certain level is beneficial in that condition, but there is an ideal debt to equity ratio of 1 - 1.5, it varies upon the industry requirements and conditions.

Although the theory which states that reducing debt will reduce cost of equity and of debt is false as there is a tax benefit on debt which states that cost is always less of debt.

Statement b

Financial distress and bankruptcy has several reasons to occur, and one of them is borrowing.

It do not depend on the level of borrowings, whether moderate or high, borrowings demand compulsory payment in the terms of interest due, which leads to a burden on the company. This also increases the demand of shareholders.

Thus, the statement is false.