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Unformatted text preview: Current Balance Sheet Asset 100 Liabilities 10 Equity 90 Total 100 100 Equity of $10 should be bought back or reacquired by raising a liability of $10. c. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why? Initially when the firm substitutes debt for equity financing the overall cost of capital will reduce as cost of debt is cheaper than cost equity. d. If a firm uses too much debt financing, why does the cost of capital rise? Employing debt in the business increases the risk of the firm. In such a case though initially debt proves to be cheaper than equity it will ultimately increase the overall cost of capital as the equity shareholders expect a higher return because of increase in risk. Thus the cost of capital increases....
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- Spring '11