Increased use of debt, is likely to __________ of the firm provided that the cost of equity remains unaffected.
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Lower the over-all cost of capital
Option (1) Higher the over-all cost of capital — Incorrect. This is the reverse. Debt is the cheaper source, so using more of it pulls the average cost down, not up.
Option (2) Lower the over-all cost of capital — Correct. Debt is cheaper than equity for two reasons. The lender takes less risk than the shareholder, because interest and repayment are assured, so he asks for a lower return. And interest is a tax-deductible expense, while dividends are paid out of profit after tax. So more debt lowers the firm’s average cost of funds, as long as the shareholders do not start asking for a higher return because of the extra risk.
Option (3) Have no effect on the over-all cost of capital — Incorrect. Debt and equity have different costs, so changing their mix changes the average cost.
Option (4) Lower the over-all investment of capital — Incorrect. Using more debt changes where the money comes from. It does not change how much capital is invested.
NCERT (2026-27 Edition): “Capital Structure … 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. …” |
Note: The same/similar question has been asked in different years by NTA as per the details given below:
| 2026 | 2025 | 2024 | 2023 | 2022 |
| 24-05 S1 | – | – | 30-05 S1 | – |