Question

A corporation that uses both debt and equity in its capital structure has concluded that the risk premium it must pay on its common stock is too high. To decrease​ this, the firm can
A) increase the proportion of long-term debt to decrease the cost of capital.
B) increase short-term debt to decrease the cost of capital.
C) decrease the proportion of common stock equity to decrease financial risk.
D) increase the proportion of common stock equity to decrease financial risk.

Answer 1

Answer:

A) increase the proportion of long-term debt to decrease the cost of capital.

Explanation:

Weighted average cost of capital is the average cost of all the different types of long term finance used by a firm weighted according the market value of each type.

The cost of debt is cheaper than cost of equity because the interest payment on debt  are tax deductible. That is interest costs help reduce te amount payable as tax. According to the traditional theory of WACC, to a reasonable level, the more debt a company uses the lower the WACC.

Cost of equity is higher the cost of debt because the risk associated with holding shares from the perspective of the investors is higher because equity holders receive residual income after other claims have been settled. So they are real risk bearer.

So to reduce the overall  cost of capital, the corporation should to increase the proportion of  long-term term