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Question An all-equity firm’s stockholders currently require a 10 percent return on their investment. One of the directors of the company suggests that the firm can lower its weighted average cost of capital by issuing debt since bondholders are only expected to require a 4 percent return. This implies that the value of the firm will increase, the director argues, because the “hurdle rate” on new investment will be lower. Comment on the director’s arguments.

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Question

An all-equity firm’s stockholders currently require a 10 percent return on their investment. One of the

directors of the company suggests that the firm can lower its weighted average cost of capital by issuing debt since bondholders are only expected to require a 4 percent return.  This implies that the value of the firm will increase, the director argues, because the “hurdle rate” on new investment will be lower.  Comment on the director’s arguments. 

 
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