An investment banker is advising a company on its optimal capital structure. The company currently has a debt-to-total-capitalization ratio of 20% and an investment-grade credit rating. If the company increases leverage to 50%, which of the following is the most likely consequence?

Why B — The cost of equity will increase to reflect higher financial risk, and the credit rating may be downgraded

Significantly increasing leverage from 20% to 50% debt-to-capitalization raises financial risk for both equity and debt holders. Equity holders face greater earnings volatility due to the fixed interest obligations, causing the cost of equity (and equity beta) to rise. Credit rating agencies may downgrade the company due to higher leverage ratios and reduced financial flexibility, which would increase future borrowing costs. While some WACC benefit exists from the debt tax shield, it may be offset by the higher costs of both equity and debt at elevated leverage levels.