Bryco, Inc. is financed solely with equity. The firm is considering utilizing de

Question

Bryco, Inc. is financed solely with equity. The firm is considering utilizing debt in its capital structure to finance a new project. If the firm issues debt, the credit rating will be AAA. The firm should increase its financial leverage because

a.       Interest payments are tax deductible

b.       With little debt, the probability of default should be extremely low, so the expected cost of bankruptcy is very low.

c.        Management currently owns 50% of the stock and by issuing debt, management can maintain control of the firm.

d.       All of the above

Explanation / Answer

The firm should increase financial leverage because with increase in debt in the capital structure the cost of capital would decrease. When the cost of capital decreases the return on common equity for the firm will increase which will benefit the common equity shareholders. Althought the cost of debt is less then cost of equity. Increase of debt in the capital structure should be used in caution because with more debt comeas an added obligaton of regular interest payments to the debt lenders. Also, in case of liquidation the preference of debt lenders is higher than that of common equity.

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