What happens to the cost of debt as leverage increases beyond a point?

• A. Cost of debt remains constant.
• B. Cost of debt decreases indefinitely.
• C. Cost of debt increases after a threshold due to risk.
• D. Cost of debt equals cost of equity.

Answer: (C)

As leverage grows, the firm’s financial risk rises. The cost of debt is the yield lenders require to lend to the firm, which reflects the probability of default and potential distress. Up to a certain level of debt, this risk is manageable and the cost may stay relatively low (and the after-tax cost can look favorable due to interest deductibility). But once leverage passes a threshold, the incremental risk becomes more significant, and lenders demand higher interest rates to compensate for the greater chance the company can’t meet its obligations. So the cost of debt increases after that point because of the heightened risk.