CFA Practice Question

There are 120 practice questions for this study session.

CFA Practice Question

Using greater amounts of debt in the capital structure ______
A. decreases the cost of debt because it reduces the amount of the equity holders' claims on the earnings stream.
B. increases the cost of debt because bondholders must compete with equity holders for the earnings stream.
C. increases the cost of debt because increasing numbers of bondholders are competing for the same earnings stream.
Explanation: Using greater amounts of debt in the capital structure increases the cost of debt because increasing numbers of bondholders are competing for the same earnings stream.

User Contributed Comments 9

User Comment
murli More debt means more cost of debt, as same earnings has to cover more debt.
Angelique I don't agree. Earnings don't determine what bondholders are paid. Firm could earn 0 and creditors must still be paid. This is FIXED income. What does increase the cost of debt is the increasing probability of bankruptcy.
MGM13 While earnings don't determine what bondholders are paid, the firm is still obligated to pay them, as you indicate. The cost of debt rises because if the firm were to issue new debt, they'd have to offer a higher rate to prospective bond purchasers in order to sell the bonds. Basic supply and demand. More debt outstanding = more risk (of default on bond payments, bankruptcy, etc.).
kenanand another way to look at it is: more the debt, the interest coverage ratio will be less; bondholders will treat this as risky and expect higher return for the bond
lagoste we know that cost of equity is usually higher than cost of debt. increasing the amount of debt should reduce WACC.
treakj Lender competes with other lenders, it does not compete with a shareholder because lender has preference against them.
achu C is the best choice of a mediocre lot. Bondholders are competing with each other to get repaid; strictly speaking it could come out of items besides earnings -e.g. hard assets contributed by the equity holders. In a perfect world, however, where borrowings are all paid out of earnings, C makes sense.
Lambo83 C is correct but the part about 'bondholders competing with each other' doesn't make sense. If they were competing they would be offering a lower yield to the company. Simply the reason the cost of debt increases, as MGM13 explained, is because of higher risk to the company for every additional dollar of debt.
kingirm Agree with Lambo. Cost of debt will rise becuz bondholders will see the company riskie
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