CFA Practice Question

There are 120 practice questions for this study session.

CFA Practice Question

Using greater amounts of debt in the capital structure increases the cost of equity because ______

A. debt holders have first claim on the firm's net income.
B. equity holders only receive income after the debt holders' claims have been met.
C. Greater amounts of debt in the capital structure do not increase the cost of equity.
Correct Answer: B

Greater amounts of debt in the capital structure increase the cost of equity because equity holders only receive income after the debt holders' claims have been met.

User Contributed Comments 11

User Comment
katya37 doesn't A say the same thing?
nike not exactly, katya37. There are other groups that come before debt-holders. The certain thing is that equity holders come after debt holders, but you cannot say debt holders are the first.
Rotigga Payment of Taxes takes precedence over debt holders, so A is not the answer.
ssradja good point rotigga
tabulator Net income is after-tax, Rotigga
gulfa99 debt holders dont have claim to the firms net income. Debt holders are paid interest for lending money, where as net income after interest cost and taxes goes to reserve or is paid as dividend. Equity holders have right over the net incom.
bidisha yup gulfa
jonan203 katya, it depends on where the type of debt (senior, subordinated, mezzanine, etc) you own lies on debt pecking order.

just because you hold debt, doesn't mean your first in line, irrespective of taxes.
tybe0012 COST OF equity
ascruggs92 Equity holders are last in the pecking order, that's why their claim to the firm's revenues is the bottom line of the income statement. The equity holders' claim to firm's revenues (net income) is net of interest expense. Therefore debt holders do not have first claim to Net Income because their claim on the firm's revenue is factored into net income and therefore has already been met. If it said "debt holders have first claim to EBIT," then A would be correct.
walterli why not C lmao
You need to log in first to add your comment.