Question

Discuss the notion of conservation of risk, the reduction of risk in one area is offset by increased risk in another area. As the firm makes capital structure changes, the total risk remains the same. Explain the effect on the cost of equity with the addition of leverage, does the cost of equity increase, decrease or remain constant? Why? What is the impact to the weighted cost of capital does it increase, decrease or remain constant? Why?

Answer 1

Answer:

Part 1

remain constant, costs from different sources

Part 2

decreases, Leverage has a tax shield due to a deduction allowed for interest

Explanation:

Debt is another term used for Leverage. Addition of leverage does not affect the cost of equity. Cost of equity and cost of debt are costs from different sources

However, Leverage has a tax shield due to a deduction allowed for interest. Therefore as more debt is used, the cost of capital decreases. So weighted average cost of capital calculates costs from pooled resources