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Steve Cooley, the Chief Financial Officer for Canberra Corporation, decides that he wants to use as much debt as possible in his firm’s capital structure. Cooley knows that to use more debt, he will need to make a persuasive argument to his board. Which of the following arguments used by Cooley to help with his goal of raising large amounts of additional debt is least supported by empirical evidence? A)
| The cost of debt is always cheaper than the cost of equity. |
| B)
| Increasing the amount of debt has an insignificant impact on our credit risk premium. |
| C)
| Raising additional debt provides a signal to our shareholders that our firm’s future prospects are positive. |
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Athough it is not the only factor, increasing the amount of debt will put downward pressure on the company’s credit rating, resulting in an increase in the credit risk premium. This will in turn increase the costs of both debt and equity capital. Note that raising additional debt does provide a positive signal about future prospects. Also, saying that the cost of debt is always cheaper than the cost of equity is an accurate statement, but the static trade-off theory shows how balancing debt and equity capital can lead to lower costs for both components |
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