If return on Investment is high, increased use of debt, is likely to ________ cost of capital of the firm provided that the cost of equity remains unaffected.

Reduce

The correct answer is Option 1 - Reduce.

If return on Investment is high, increased use of debt, is likely to reduce cost of capital of the firm provided that the cost of equity remains unaffected.

Debt and equity differ significantly in their cost and riskiness for the firm. The cost of debt is lower than the cost of equity for a firm because the lender’s risk is lower than the equity shareholder’s risk, since the lender earns an assured return and repayment of capital and, therefore, they should require a lower rate of return. Additionally, interest paid on debt is a deductible expense for computation of tax liability whereas dividends are paid out of after-tax profit. Increased use of debt, therefore, is likely to lower the over-all cost of capital of the firm provided that the cost of equity remains unaffected.