There are
two effects of introducing debts by the companies i.e. substitution effect and
financial effect.
1.
Substitution effect
The cost of capital is expected to reduce by introducing debt
financing because debt are cheaper than equity due to lower risk associated
with debt financing. The cost of capital
is expected to reduce due to the cheaper financing i.e. debt financing.
2.
Financial effect
The risk of default increases with the introduction of more
debt and this risk is fully born by equity holder because debt financing are
secured by the capital assets. Therefore
equity holder will demand higher return for risk associated with debt financing
i.e. default risk. Increase in cost of equity will raise the cost of capital.
3.
Net effect of Debt financing
The debt financing on one hand reduce the cost of capital due
to lower cost associated with debt financing and on other hand it raises the
cost of capital due to rise in the cost of equity. The substitution effect and
financial effect as counter forces to each other.
