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Unformatted text preview: capital, and why? Current Balance Sheet Asset 100 Liabilities 10 Equity 90 Totals 100 100 Optimal Capital Structure Balance sheet Asset 100 Liabilities 20 Equity 80 Totals 100 100 As a firm initially substitutes debt for equity financing, the cost of capital decreases. The cost of capital decreases because the after-tax cost of debt is lower than the cost of equity. d) If a firm uses too much debt financing, why does the cost of capital rise? Too much debt financing causes the cost of capital to rise because the firm is putting themselves at risk for possible default or bankruptcy. Because of this risk, investors require a higher rate of return as compensation for this risk. Now that the cost of equity increases, it causes the overall cost of capital to increase as well....
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